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Finance: Net present value

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A risky project is expected to last four years and required an initial investment of $10,000 in year 0. The project is expected to generate cash flows of $2,000 in year 1; $4,000 in year 2; $3,000 in year 3; and $3,000 in year 4. The company's debt to equity ratio is equal to 1, and is expected to remain constant for the entire life of the project. The beta of the company's equity is equal to 2, the rate of return on one year government bonds is 3%, the market risk premium is estimated at 4%, and the rate of return on the company's bonds is 7%. Assume no taxed.

(i) Determine the net present value of the project using the company's beta to measure the project's exposure to systematic risk. Is the project profitable?

(ii) Would your opinion of the project change if you knew that the company is in a mature market, its operation and its leverage are not every different from those of other companies in the same industry, and the equity beta of the industry to which the company belongs is 1? Discuss.

(iii) Discuss the determinants of a company's beta?

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Solution Preview

A risky project is expected to last four years and required an initial investment of $10,000 in year 0. The project is expected to generate cash flows of $2,000 in year 1; $4,000 in year 2; $3,000 in year 3; and $3,000 in year 4. The company's debt to equity ratio is equal to 1, and is expected to remain constant for the entire life of the project. The beta of the company's equity is equal to 2, the rate of return on one year government bonds is 3%, the market risk premium is estimated at 4%, and the rate of return on the company's bonds is 7%. ...

Solution Summary

The problem deals with determining the net present value of a decision.

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