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Country Wallpapers is considering investing in one of three mutually exclusive projects, E, F, and G. The firm’s cost of capital, r, is 15%, and the risk free rate, Rf, is 10%. The firm has gathered the basic cash flow and risk index data for each project as shown in the following table.

Project (j)

E

F

G

Initial Investment (CF0)

-$15,000

-$11,000

-$19,000

Year (t)

Cash Inflows

1

$6,000

$6,000

$4,000

2

6,000

4,000

6,000

3

6,000

5,000

8,000

4

6,000

2.000

12,000

Risk index (RIj)

1.80

1.00

0.60

Find the net present value (NPV) of each project using the firm’s cost of capital. Which project is preferred in this situation?

The firm uses the following equation to determine the risk-adjusted discount rate, RADR, for each project j: RADRj=Rf + [RIj x (r-Rf)]

Where: Rf=risk free rate of return

RIj=risk index for project j

r=cost of capital

Substitute each project’s risk index into this equation to determine its RADR.

Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this situation?

Compare and discuss your finding in part a and c. Which project do you recommend that the firm accept?Country Wallpapers is considering investing in one of three mutually exclusive projects, E, F, and G. The firm’s cost of capital, r, is 15%, and the risk free rate, Rf, is 10%. The firm has gathered the basic cash flow and risk index data for each project as shown in the following table.

Project (j)

E

F

G

Initial Investment (CF0)

-$15,000

-$11,000

-$19,000

Year (t)

Cash Inflows

1

$6,000

$6,000

$4,000

2

6,000

4,000

6,000

3

6,000

5,000

8,000

4

6,000

2.000

12,000

Risk index (RIj)

1.80

1.00

0.60

Find the net present value (NPV) of each project using the firm’s cost of capital. Which project is preferred in this situation?

The firm uses the following equation to determine the risk-adjusted discount rate, RADR, for each project j: RADRj=Rf + [RIj x (r-Rf)]

Where: Rf=risk free rate of return

RIj=risk index for project j

r=cost of capital

Substitute each project’s risk index into this equation to determine its RADR.

Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this situation?

Compare and discuss your finding in part a and c. Which project do you recommend that the firm accept?


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29 Sep 2019
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Related questions

Consider a project with free cash flows in one year of $90,000 in aweak economy or $117,000 in a strong economy, with each outcomebeing equally likely. The initial investment required for theproject is $80,000 and the project’s cost of capital is 15%. Therisk-free interest rate is 5%.

Suppose that to raise the funds for the initial investment the firmborrows $80,000 at the risk-free rate, then the value of the firm’slevered equity from the project is closest to:

(1) $0
(2) $10,000
(3) $6,000
(4) $8,600

  1. Calculate the present value of a growing perpetuity with thefirst cash flow (occurring in one year) being $10 million and everysubsequent year’s cash flow growing at a constant 6% rate (i.e, thecash flow at the end of two years is $10M(1.06) = $10.6 million,the cash flow at the end of three years is 10M(1.06)^2 = $11.236million, etc.). The cost of capital for this calculation is12%.

  2. The firm has to spend $50 million immediately and $25 millionone year from now to start a new investment project. The firm’scost of capital is 12%. What is the present value of the firm’sexpenditures to start the new investment project?

  3. The firm is considering the investment project in problem 2,where they invest $50 million immediately and $25 millionadditionally one year from now. There are no other cash inflows oroutflows for the project until the end of five years, at which timethe first cash inflow from the project is $10 million. After thisfirst cash inflow, the cash flows grow each year at 6%,indefinitely. The cost of capital for this project is 12%.Calculate the Net Present Value of this investment.

  4. The NPV of the investment in problem 3 depends on the growthrate in perpetuity of the cash inflows. For example, if the growthrate were 4% rather than six percent, the NPV of the project wouldbe lower. For what value of the growth rate is the NPV of theproject zero? (In other words, how high does the growth rate inperpetuity have to be for this project to be positive NPV?)

    The following questions use the Capital Asset Pricing Model. Youhave the following market- wide parameters: the risk-free rate ofinterest in the economy is 3% and the risk premium on the marketportfolio (i.e., the market risk premium) is 6%.

  5. What is the expected return on a stock with a beta of 1.5?

  6. What is the expected return on a stock the return on which isuncorrelated with the return on the market portfolio?

  7. What is the beta of a portfolio where half of the money in theportfolio is invested in the market index and half the money in theportfolio is invested in risk free securities? What is the expectedreturn on such a portfolio?

QUESTION 6 [Total 29 marks]

A listed company has a proposed investment project where the expected cash flows are given in the table below. Market research into a feasibility study for the project was conducted at a cost of $5,000. The risk-free rate of return is given as 2% per annum. The yearly return for the Australian share market is given as 12%. Suppose the company has a beta value of 0.8.

Year 0 Project cash flow $(20,000)

Year 1 Project cash flow $(10,000)

Year 2 Project cash flow $(20,000)

Year 3 Project cash flow $(10,000)

Year 4 Project cash flow $(40,000)

Year 5 Project cash flow $(30,000)

(a) Determine the project’s discount rate. (4 marks)

(b) Explain what is meant by sunk costs in capital budgeting. State the amount of any sunk costs for the project. (2 marks)

(c) What type of risk does the beta value measure? Explain what is meant by this particular type of risk. (2 marks)

(d) If the maximum acceptable payback period for the project is 3 years, would the project be accepted? What are the disadvantages of the payback period method in making investment decisions? (5 marks)

(e) Explain the difference between the discounted payback period method and the payback period method. Would the project be accepted if the discounted payback period is used instead of the payback period? (5 marks) 5

(f) Explain whether the project would be accepted using the net present value (NPV) acceptance criterion. Explain why the NPV method is considered to be the best method in capital budgeting. (5 marks)

(g) Explain whether the project would be accepted using the profitability index (PI) acceptance criterion. (3 marks)

(h) Explain whether the project would be accepted using the internal rate of return (IRR) acceptance criterion. Explain why the IRR method is widely used in capital budgeting. (3 marks)

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