Question 5: (8 marks) At present, FT Inc. has 1 million shares outstanding, and

Question

Question 5: (8 marks) At present, FT Inc. has 1 million shares outstanding, and the firm's net income is $4 million. The company has decided to invest in a new project today. The project requires an investment of $3 million today and an additional $2 million one year from today. The project will start to generate cash inflows from the end of year 2. The cash inflow will be $2 million in perpetuity. The risk- free rate is 6%, and the market risk premium is 4%. In addition, the beta of FT is 1.5. Using the NPVGO model, calculate the value of the stock of FT Inc. today.

Explanation / Answer

Required rate of return = 6% + (4% × 1.50)

= 6% + 6%

= 12%

Required rate of return is 12%.

Present value of cash inflow at begining of year 2 = $2 million / 12$%

= $16.67 million.

Present value of cash inflow today = $16.67 / (1 + 12%) ^ 2

= $16.67 / 1.2544

= $13,286,565.

Present value of cash inflow is $13,286,565.

Present value of cash out flow = $3 + $2 / (1 + 12%)

=$4,785,714

NPV of project = $13,286,565 - $4,785,714

= $8,500,851.

NPV of project is $8,500,851.

Since, NPV of project is a positive value, so project should be accepted.

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