Question

Logic Legal Leverage (LLL) is evaluating a project that has a beta coefficient equal to 1.3. The risk- free rate is 3 percent and the market risk pre- mium is 6 percent. The project, which requires an investment of $405,000, will generate $165,000 after-tax operating cash flows for the next three years. Should LLL purchase the project? Excuse me, but I am stumped on this and the answer listed feels incorrect to me. Any thoughts?

Answer 1

Step-1, Calculation of the Required rate of return

As per Capital Asset Pricing Model [CAPM], the Required Rate of Return is calculated by using the following equation

Required Rate of Return = Risk-free Rate + [Beta x Market Risk Premium]

= 3.00% + [1.30 x 6.00%]

= 3.00% + 7.80%

= 10.80%

Step-2, The Net Present Value (NPV) of the Project

Year	Annual Cash flow ($)	Present Value factor at 10.80%	Present Value of Annual Cash flow ($)
1	1,65,000	0.9025271	1,48,916.96
2	1,65,000	0.8145551	1,34,401.60
3	1,65,000	0.7351581	1,21,301.08
TOTAL			4,04,619.64

Net Present Value (NPV) of the Project = Present value of annual cash inflows – Initial investment costs

= $404,619.64 - $405,000

= $380.36 (Negative NPV)

Ste-3, Decision to accept or reject the project

Evaluation of Investment proposal using NPV Decision Rule

As per NPV Decision Rule, the Project should be accepted only if the NPV is Positive, else, Reject the Project. Here, the NPV of the Project is -$380.36 (Negative NPV), therefore, the Project should not be purchased.

NOTE

The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)ⁿ], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.