You are a consultant to a large manufacturing corporation considering a project

Question

You are a consultant to a large manufacturing corporation considering a project with the following net after- tax cash flows (in millions of dollars): The project?s beta is 1.4. Assuming rf= 5% and E(rM) = 15%. a. What is the net present value of the project? (Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.) Net present value million b. What is the highest possible beta estimate for the project before its NPV becomes negative? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Highest possible beta value

Explanation / Answer

We have to first calculate weighted average cost of capital (WACC) by using the following formula

WACC = Rf + * (E(rM) - Rf )

In words it is the sum of risk free rate plus Beta times risk premium where risk premium is rate of equity minus risk free rate

WACC = 5% + 1.4 * (15% - 5%) = 19%

a. To get net present value of the project we have to discount all cash flows to present values as shown in the below table

PV = CF / (1 + R)t

The total of all PV’s is 35.20

So the present value of the project is 35.20

b. We have to first calculate IRR, i.e. when NPV = 0

There are 2 ways of finding IRR

I.Trial and Error method

This takes lot of time

II.Using Microsoft excel

Use formula IRR(A1:A10)

Enter 10 cash flow numbers in the cells A1 to A10

We get IRR as 50%

Now to calculate highest possible , substitute WACC with 50 % in the below equation and remaining values as used above.

WACC = Rf + * (E(rM) - Rf )

50% = 5% + * (15% - 5%)

After solving we get as 4.50

Year After Tax CF PV 0 -28 -28.00 1 14 11.76 2 14 9.89 3 14 8.31 4 14 6.98 5 14 5.87 6 14 4.93 7 14 4.14 8 14 3.48 9 14 2.93 10 28 4.92

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