Question

Teal Inc. now has the following two projects available: Project Initial CF 1 After-tax CF1 4,800 3,300 After-tax CF3 8,600 -11,337 -3,092 After-tax CF2 5,450 2,700 2 Assume that Rp = 4.1%, risk premium = 9.6%, and beta = 1.1. Use the chain replication approach to determine which project(s) Teal Inc. should choose if they are mutually exclusive. (Round cost of capital to 2 decimal places, e.g.17.35% and the final answers to o decimal places, e.g. 2,513.) NPV1 generated over a six-year period NPV2 generated over a six-year period should be chosen.

Answer 1

Cost of Equity using CAPM =Risk free Rate+Beta*Market Risk Premium =4.1%+1.1*9.6% =14.66%

Cash flow of Project 1 in case of replacement
Cash Flow Year 0 =-11337; Cash Flow Year 1=4800;CF2=5450;CF3=8600-11377=-2737;CF4=4800;CF5=5450;CF6=8600
NPV 1 =PV of Cash Flows -Initial Investment
=4800/(1+14.66%)+5450/(1+14.66%)^2+-2737/(1+14.66%)^3+4800/(1+14.66%)^4+5450/(1+14.66%)^5+-8600/(1+14.66%)^6-11337 =4491

Cash flow of Project 2 in case of replacement
Cash Flow Year 0 =-3092; Cash Flow Year 1=3300;CF2=2700-3092=-392;CF3=3300;CF4=2700-3092=-392;CF5=3300;CF6=2700
NPV 1 =PV of Cash Flows -Initial Investment
=3300/(1+14.66%)+-392/(1+14.66%)^2+3300/(1+14.66%)^3+-392/(1+14.66%)^4+3300/(1+14.66%)^5+2700/(1+14.66%)^6-3092 =4304

Project 1 should be chosen as it has higher NPV