Question

You are evaluating the following project. All $ are in millions Initial cost of the project at t-0 is $70. Annual cash flows from the project depends on the demand for the product and is estimated to be as follows: With probability of 30%, the demand is high and the annual cash flow is $45 With probability of 40%, the demand is average and the annual cash flow is $30 With probability of 30%, the demand is low and the annual cash flow is $15 The above cash flows 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 and stocks. The company will issue a ten-year bond at par with the coupon rate of 5%. The company's stock has a beta of 2.1. The risk-free rate is 2.07% and the market risk premium is 6%. The marginal tax rate of the firm is 40%. The firm's target and current capital structure is 40% debt and 60% equity. Questions: (in your calculations, please keep up to two decimal points after 90 For example, 12.34%.) 1. What is the expected NPV of the project? 2. What feature of the project makes the managers hesitant with starting this project? 3. Now assume that if we wait one year, we will gain additional information regarding demand. That is, at t-1, we will know whether the demand will be high, average, or low. (The probability of the demand is 30%,40%,30% at t-0 and then becomes certain at t=1). Find out the expected NPV of the proiect.

In excel or Word doc please

Answer 1

		Before tax Cost of Debt	5%
		Tax rate=40%=	0.4
		After tax cost of debt =5*(1-0.4)=	3.00%
		Cost of Equity =Risk Free Rate+Beta*(Market Risk Premium)
		Cost of Equity =2.07%+2.1*6%=	14.67%
		Weight of Debt in total   Capital	0.4
		Weight of Equity in total   Capital	0.6
		Weighted Average Cost of Capital
		WACC=0.4*3+0.6*14.67=	10.00%
		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=WACC=10%	0.1
		N=Year of Cash Flow
		Expected Annual Cash Flow	30	(0.3*45+0.4*30+0.3*15)
	N	Year	0	1	2	3
	CF	Expected Cash Flow($ million)	($70)	$30	$30	$30	SUM
	PV=CF/(1.1^N)	Present Value of Cash Flow($ million)	($70)	$27.27	$24.79	$22.54	$4.61
		Expected NPV of the Project	$4.61	Million
	2	Variablity of cash flow makes Management hesitant to take up the project