A project requires an initial investment in equipment of $760,000 immediately (t=0) and is expected to produce sales revenue of $697, 000 the first year; this revenue will increase by 4.5% per year over the next four years. Manufacturing costs are estimated to be 67% of the sales. The project demand analysis, which was done last year, cost $235,000. The asset can be depreciated on a straight-line basis over five years to a zero salvage value. The corporate tax rate is 36%. The project requires an investment in working capital. Specifically, at the beginning of the project (t=0), $45,000 of working capital is required; thereafter, working capital is projected to be 6.0% of revenue. The investment in working capital will be recovered at the end of the fifth year. At the end of the 5th year, the company plans to sell the equipment for $18,900. To calculate the cost of capital for this project, the firm is going to use the following companies as comparable firms. Beta Debt Equity XOM 1.00 11.63B 403.10B CVX 1.22 20.02B 224.24B Assume that the market risk premium is 6%, the risk free-rate is 5%, and all debt is risk free, static and perpetual, and that the CAPM holds. The firm is going to finance the project with all equity. QUESTION: Suppose the firm can expand the value of the project by 50 percent at the end of year 1 with an additional investment of $500,000. Further, the firm has the option to sell the asset to another firm at the end of year 1 for $600,000. If the returns of the project have a standard deviation of 25% and the risk-free rate is 5%, what is the value of the project including these options? Use a binomial tree with 2 steps to determine the value
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
A project requires an initial investment in equipment of $760,000 immediately (t=0) and is expected to produce sales revenue of $697, 000 the first year; this revenue will increase by 4.5% per year over the next four years.
To calculate the cost of capital for this project, the firm is going to use the following companies as comparable firms.
|
Beta |
Debt |
Equity |
|
|
XOM |
1.00 |
11.63B |
403.10B |
|
CVX |
1.22 |
20.02B |
224.24B |
Assume that the market risk premium is 6%, the risk free-rate is 5%, and all debt is risk free, static and perpetual, and that the
QUESTION: Suppose the firm can expand the value of the project by 50 percent at the end of year 1 with an additional investment of $500,000. Further, the firm has the option to sell the asset to another firm at the end of year 1 for $600,000. If the returns of the project have a standard deviation of 25% and the risk-free rate is 5%, what is the value of the project including these options? Use a binomial tree with 2 steps to determine the value
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