Your company is considering a project (expanding its household product division). Your company is a private company and there are no securities issued and traded in public financial markets. Assume that the project will be 100% equity financed. The initial investment would be 10 million dollar and free cash flows (FCF) for next four years are estimated. Tax rate is 40%.
o FCF at t=1: 3 million
o FCF at t=2: 4 million
o FCF at t=3: 4 million
o FCF at t=4: 6 million
You need to estimate the cost of capital for the project and perform a NPV analysis to evaluate this project. You have the following information.
You found a comparable company in the same line of business, which is also 100% equity financed. Risk free rate = 3%, market risk premium = 5%, and estimated beta of this comparable company is 0.83
You found a comparable company in the same line of business, but the comparable company has a debt (30% of leverage ratio). Cost of equity = 6% and cost of debt is 4%
This solution estimates the net present value of a capital project given an estimate of cost of capital based on a comparable company with all formulas and workings shown in an excel file.
Compute free cash flow, initial outlay, terminal cash flow, NPV, IRR. Discuss project risk, CAPM, simulations and sensitivity analysis.
Using data in the attached excel file, respond to these:
Should the company focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows,
incremental profits, total free cash flows, or total profits?
How does depreciation affect free cash flows?
How do sunk costs affect the determination of cash flows?
What is the projects initial outlay?
What are the differential cash flows over the projects life?
What is the terminal cash flow?
Draw a cash flow diagram for this project?
What is its net present value?
What is its internal rate of return?
Should the project be accepted? Why or why not?
In capital budgeting, risk can be measured from three perspectives. What are those three measures of a projects risk?
According to CAPM, which measurements of a projects risk is relevant? What complications does reality introduce into the CAPM view of risk, and what does that
mean for our view of the relevant measure of a projects risk?
Explain how simulation works. What is the value in using a simulation approach?
What is sensitivity analysis and what is its purpose?