Cheng Incorporated is considering the purchase of a new piece of equipment. It w

Question

Cheng Incorporated is considering the purchase of a new piece of equipment. It would cost $150 and be depreciated over a life of 5 years to a zero salvage value using the straight-line method. If the purchase is made, Cheng estimates the following probability distribution of revenues less operating expenses for each year:

{a} Assume that Cheng operates only in one industry and is not diversified.

Cheng has a marginal tax rate of 40% and the new investment would require additional net working capital of $50. The risk-free rate is 5%, the investment?s beta is 2 and the market?s risk-premium over and above the risk-free rate is 6.5%.

Calculate the risk-adjusted NPV of the investment if there is a 50% chance the equipment will actually last only 4 years and be scrapped for $40 and a 50% chance it will actually last 12 years at which time its scrap value will be zero.

{b} Now assume that Cheng is a well-diversified conglomerate operating in a wide-variety of industries. Calculate the risk-adjusted NPV if the information in {a} still holds. ?

{c} Explain the circumstances under which Cheng should use the Beta Model; i.e., must Cheng be diversified or just in one or two lines of business? What is systematic risk and what is unsystematic risk? Which does beta account for and what happens to the other one? ?

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