Returns on the market and Company Y\'s stock during the last 3 years are shown b

Question

Returns on the market and Company Y's stock during the last 3 years are shown below:
Year Market Company Y
2007 -24% -22%
2008 10 13
2009 22 36

The risk-free rate is 5% and the required rate of return on the market is 11%. You are considering a low risk project whose market beta is 0.5 less than the company's overall corporate beta. You finance only with equity, all of which comes from retained earnings. The project has a cost of $500 million, and its expected to provide cash flows of $100 million per year at the end of years 1 through 5 and then $50 million per year at the end of years 6 through 10. What is the project's NPV (in millions of dollars)?

Explanation / Answer

Find corporate Beta first,

Beta = Covariance / Variance of stock market

Mean return of the market = 2.67%
Mean return of the company Y = 9%
Covariance = (-24-2.67)(-22-9)+(10-2.67)(13-9)+(22-2.67)(36-9) = 459.33
Variance of stock market = (1/3)[(-24-2.67)2+(10-2.67)2+(22-2.67)2] = 379.56

Corporate Beta = 459.33/379.56 = 1.21

Required Beta, = 1.21 - 0.5 = 0.71

Re = Rf+(Rm-Rf) = 5+0.71(11-5) = 9.26%

NPV = 100/1.0926+100/1.09262+100/1.09263+100/1.09264+100/1.09265+

        50/1.09266+50/1.09267+50/1.09268+50/1.09269+50/1.092610

NPV = 510.42 million

Related Questions

Navigate

• Browse (All)
• Browse R
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.