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 Subject: Beta & Risk Category: Business and Money > Finance Asked by: bladehulk-ga List Price: \$11.00 Posted: 19 Nov 2006 21:31 PST Expires: 19 Dec 2006 21:31 PST Question ID: 784165
 ```XYZ is an all equity firm with a beta of 0.95. The market risk premium is 9% and the risk-free rate is 5%. The company is considering a project that will bring in cash flows of \$340,000 at year end for 5 years. The project requires an immediate investment of 1.2 million. Should XYZ take this project if it has the same risk as the firm as a whole?``` ```Hi!! According to the statement this project has the same risk as the firm as a whole, therefore the discount rate for the project (Rp) is equal to the expected return on the company equity (Re), applying the CAPM we can find both: Rp = Re = Rf + Beta*Rmp = = 5% + 0.95*9% = = 13.55% Now calculate the NPV of the project to see if it is profitable: NPV = PV of Cash Flows - Investment (or initial cash flow) The hard part of the above formula is the PV of the cash flows: CF1 CF5 PV = ---------- + .... + ---------- (1 + Rp)^1 (1 + Rp)^5 Then: CF1 CF5 NPV = ---------- + .... + ---------- - I (1 + Rp)^1 (1 + Rp)^5 In cases like this, when all the cash flows are equal, the PV formula can be simplified: CF 1 PV = ---- * [1 - ----------] Rp (1+Rp)^5 And we will have that: CF 1 NPV = ---- * [1 - ----------] - I = Rp (1+Rp)^5 = (340,000/0.1355)*[1-(1/1.1355^5)] - 1,200,000 = = -20,016.52 Since the project has a negative NPV it must be rejected. See the following page for further explanations: "Methods/Criteria of Project Evaluation or Measures of project Worth of Investment" by Dr. A.K. Sarma: http://www.assamagribusiness.nic.in/agriclinics/Methods%20criteria.pdf Search strategy: "project evaluation" I hope this helps you. Feel free to request for a clarification if you need it. Regards, livioflores-ga```  