Question

Suppose you are the CEO of MotorABC, and you are considering investing in the following project. The life cycle of the project takes 6 years. During the first three years, the project requires fixed investments, and the project generates risky earnings throughout its life cycle.

The investments committed to the project are shown in the following table:

Year 0 1 2 3

Investments (million) 6 6 6

The expected earnings from the project are shown in the following table:

Year 0 1 2 3 4 5 6

Earnings (million) 5 5 5 5 5 5

Suppose the yield curve (EAR) is flat at 1%, and the discount rate for the risky Earnings is flat at 20%. You are standing at time 0 now. State any additional assumptions you need to make.

(a) What is the NPV of the project. Would you invest in this project?

(b) Suppose now the earnings for the first three years (1,2,3) are guaranteed and no longer risky while the risk of the remaining earnings stays the same, would you invest in the project? Explain.

Answer 1

First of all for answering this question we are assuming that all cashflows occur at the end of the year

Risf free rate = 1%, Expected return for risky assets = 20%

a) NPV of the Project is 3.99 million at the discounting rate of 20% which is the expected rate of return considering the riskiness of earnings. So, We can invest in this project. See calculations in the below Table

b) If the first 3 years has guaranted earnings, the discount rate will be 1% for 3 years and then it will 20% for the remaining 3 years. NPV of this project will be 3.15 million. We can still invest in this project since the NPV is positive. See calculations in the below Table.