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Company Risks vs. Project Risks

Both Eastman Chemical company, a large natural gas user, and Van Oil, a major natural gas producer, are thinking of investing in natural gas wells near Houston.

Both are all-equity-financed companies. Eastman and Van Oil are looking at identical projects. They have analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be the same for both companies. No debt would be use to finance the projects.

Both companies estimate that their project would have a net present value of $1million at an 18 percent discount rate and a -$1.1 million NPV at a 22 percent discount rate.

Eastman has a beta of 1.25, where Van Oil has a beta of .75.

The expected risk premium on the market is 8 percent, and risk-free bonds are yeilding 12 percent.

Should either company proceed? Should both? Why?

Solution Preview

The required rate of return for Eastman = risk free bond rate + beta*market risk premium
=12%+8%*1.25=22%
The required rate of return for Van Oil = risk free bond ...

Solution Summary

Company Risks vs. Project Risks are assessed.

$2.19