Company Risk versus Project Risk Both Dow Chemical Company, a large natural gas

Question

Company Risk versus Project Risk Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major natural gas producer, are thinking of investing in natural gas wells near Houston. Both are all equity financed companies. Dow and Superior are looking at identical projects. They’ve analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be the same for both firms. No debt would be used to finance the projects. Both companies estimate that their projects would have a net present value of $1 million at an 18 percent discount rate and a ?$1.1 million NPV at a 22 percent discount rate. Dow has a beta of 1.25, whereas Superior has a beta of .75. The expected risk premium on the market is 8 percent, and risk-free bonds are yielding 12 percent. Should either company proceed? Should both? Explain your answer.

Explanation / Answer

Both the companies would be using equity for financing the project. So we need to calculate the required return or cost of equity for both the companies. We can do that by using the CAPM Equation, according to which:

Cost of Equity = Risk free rate + Beta * Market risk premium

For Dow,

Cost of equity = 12% + 1.25 * 8% = 22%

For Superior,

Cost of Equity = 12% + 0.75 * 8% = 18%

Hence, the discount rate for both the companies - 18% for Superior at which NPV = $1 mil and 22% for Dow at which NPV = -$1.1 mil

So, Superior should go ahead with the prject and not Dow, given for Superior, it would produce a positive NPV which implies addition of value for shareholders and firm, whereas for Dow, negative NPV means project would decrease the value of firm.

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