Question 5: (20 Points) We are evaluating an investment project that will genera

Question

Question 5: (20 Points) We are evaluating an investment project that will generate cash flows of $25,000, $40,000 and $30,000 in the next three years. The required initial investment is $70,000. Assume that the company is 100% equity finance (there is no debt in the capital structure of this company). The risk-free rate of interest of 4% and the expected market risk premium is 8%. However, we are unsure of the risk of the company. If we think the beta of the firm is 0.8, when in fact the beta is really 1.7 will we be making the correct investment decision? For how much more or less (in dollars) are we valuing the investment project?

Explanation / Answer

CONSIDERING BETA =0.8 Required return=Risk free rate of interest+Rxpected market risk premium Required return=4+(0.8*8)= 10.4 percent Discount rate=cost of capital=10.4%= 0.104 Present value of cash flow=(cash flow)/((1+i)^N) i=discount rate=0.104 N=Year of cash flow Yearwise cash flow and Present value(PV) of cash flows are given below: N A B/(1.104^N) Year Cash flow PV of cash flow 0 ($70,000) -70000 1 $25,000 22644.92754 2 $40,000 32818.73556 3 $30,000 22295.33666 Total 7758.999753 Net present value NPV $           7,759.00 CONSIDERING BETA =1.7 Required return=4+(1.7*8)= 17.6 percent Discount rate=cost of capital=17.6%= 0.176 Present value of cash flow=(cash flow)/((1+i)^N) i=discount rate=0.104 N=Year of cash flow Yearwise cash flow and Present value(PV) of cash flows are given below: N A B/(1.176^N) Year Cash flow PV of cash flow 0 ($70,000) -70000 1 $25,000 21258.5034 2 $40,000 28923.13388 3 $30,000 18445.8762 Total -1372.486521 Net present value NPV $              (1,372) If Beta is really 1.7, we are not making correct decision NPV is negative if Beta is 1.7 We are valuing the company more by =(7759+1372)= $ 9,131.49

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