You are evaluating the following project. All $ are in millions Initial cost of the project...

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You are evaluating the following project. All $ are in millionsInitial cost of the project at t=0 is $70. Annual cash flows fromthe project depends on the demand for the product and is estimatedto be as follows: With probability of 30%, the demand is high andthe annual cash flow is $45 With probability of 40%, the demand isaverage and the annual cash flow is $30 With probability of 30%,the demand is low and the annual cash flow is $15 The above cashflows occur for the next 3 years, that is, until from t=1 to t=3.The company plans to finance the project by issuing bonds andstocks. The company will issue a ten-year bond at par with thecoupon rate of 5%. The company’s stock has a beta of 2.1. Therisk-free rate is 2.07% and the market risk premium is 6%. Themarginal tax rate of the firm is 40%. The firm’s target and currentcapital structure is 40% debt and 60% equity. Questions: (In yourcalculations, please keep up to two decimal points after %. Forexample, 12.34%.)
1. What is the expected NPV of the project?
2. What feature of the project makes the managers hesitant withstarting this project?
3. Now assume that if we wait one year, we will gain additionalinformation regarding demand. That is, at t=1, we will know whetherthe demand will be high, average, or low. (The probability of thedemand is 30%,40%,30% at t=0 and then becomes certain at t=1). Findout the expected NPV of the project. The same demand continuesthroughout the life of the project. (That is, the demand ishigh-high-high with 30%, avg-avg-avg with 40%, and low-low-low with30%). The demand cannot be, for example, high-low-avg.
In Q3, the following paragraph provides further information. 3.Now assume that if we wait one year, we will gain additionalinformation regarding demand and can decide whether to do theproject or not at t=1. That is, at t=1, we will know whether thedemand for the product will be high, average, or low. (Theprobability of the demand is 30%,40%,30% at t=0 and then becomescertain at t=1). If you decide to do the project at t=1, theinitial cost occurs at t=1, and cash flow according to the demandtype will stay the same during the life of the project until t=4.Find out the expected NPV of the project at t=0.

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3.8 Ratings (409 Votes)

All cash flows are in mn Initial investment C0 70 N number of years 3 Cost of debt Kd YTM Coupon rate as bond is issued at par 5 Cost of equity Ke risk free rate Beta x market premium 207 21 x 6 1467 Proportion of debt Wd 40 Proportion of equity We 60 Tax rate T 40 Hence Discount rate See Answer

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Transcribed Image Text

You are evaluating the following project. All $ are in millionsInitial cost of the project at t=0 is $70. Annual cash flows fromthe project depends on the demand for the product and is estimatedto be as follows: With probability of 30%, the demand is high andthe annual cash flow is $45 With probability of 40%, the demand isaverage and the annual cash flow is $30 With probability of 30%,the demand is low and the annual cash flow is $15 The above cashflows occur for the next 3 years, that is, until from t=1 to t=3.The company plans to finance the project by issuing bonds andstocks. The company will issue a ten-year bond at par with thecoupon rate of 5%. The company’s stock has a beta of 2.1. Therisk-free rate is 2.07% and the market risk premium is 6%. Themarginal tax rate of the firm is 40%. The firm’s target and currentcapital structure is 40% debt and 60% equity. Questions: (In yourcalculations, please keep up to two decimal points after %. Forexample, 12.34%.)1. What is the expected NPV of the project?2. What feature of the project makes the managers hesitant withstarting this project?3. Now assume that if we wait one year, we will gain additionalinformation regarding demand. That is, at t=1, we will know whetherthe demand will be high, average, or low. (The probability of thedemand is 30%,40%,30% at t=0 and then becomes certain at t=1). Findout the expected NPV of the project. The same demand continuesthroughout the life of the project. (That is, the demand ishigh-high-high with 30%, avg-avg-avg with 40%, and low-low-low with30%). The demand cannot be, for example, high-low-avg.In Q3, the following paragraph provides further information. 3.Now assume that if we wait one year, we will gain additionalinformation regarding demand and can decide whether to do theproject or not at t=1. That is, at t=1, we will know whether thedemand for the product will be high, average, or low. (Theprobability of the demand is 30%,40%,30% at t=0 and then becomescertain at t=1). If you decide to do the project at t=1, theinitial cost occurs at t=1, and cash flow according to the demandtype will stay the same during the life of the project until t=4.Find out the expected NPV of the project at t=0.