Question

(Question 6)(LA Jear, CAPM) (Normal, Delete, WILD). L.A.Jear Inc. makes air shoes that sell at $50 each and cost $30 each to manufacture. Their existing plant produces 1000 shoes per year, which represents a significant part of the total market. They are considering investing in a new plant that will increase their capacity by 500 additional units. When the increased volume of production hits the market, the market price of shoe is expected to fall to $45. L.A.Jear is currently negotiating contracts for the construction of its new plant, which will reduce production costs to $20 each. This project has beta of 4, rm) is 10% and the interest rate is 5%. (a) What is the cost of capital for this project?(CAPM) (b) What is the maximum price that L.A.Jear should be prepared to pay for its new plant(i.e. Present Value), assuming that it can expect to retain a monopoly of the more efficient production technology indefinitely(forever)? (Hint: consider potential loss(?) from old machine by adopting new machine) (c) What would the new plant be worth to another company that did not already produce air shoes?

Answer 1

a) formula for CAPM

Ra=Rrf+Ba(Rm-Rrf)

Here beta = 4

risk free rate is = 5%

market rate is = 10%

Cost of capital will be = 5% +(10-5)% x 4 = 25%

b) firstly we have to find out the profits or losses form each old and new machinery:

old machinery profits = (50-30) *1000 = 20000

New plant = (45-20) * 1500 = 37500

present value of potential losses = (37500-20000)/0.25 = $70,000

note:

formula for present value for perpetutiy =cash flows/ discount rate or cost of capital

c) Worth of new plant to another comapny = cash flows / discount rate = 37500 / 0.25 = $150,000