Question

Hudson Furniture specializes in office furniture for self-employed individuals who work at home. Hudson’s furniture emphasizes style rather than utility and has been quite successful. The firm is now considering entering the more competitive industrial furniture market where volumes are higher but pricing is more competi- tive. A $10 million investment is required to enter the new market. Management anticipates positive cash flows of $1.7 million annually for eight years if Hudson enters the field. An average stock currently earns 8%, and the return on treasury bills is 4%. Hudson’s beta is .5, while that of an important competitor who oper- ates solely in the industrial market is 1.5. Should Hudson consider entering the industrial furniture market?

please do in word file

Answer 1

Required return for Hudson Furniture = Return on Treasury bill + Beta of important competitor * (Return on average stock - Return on Treasury bill)

= 4 % + 1.50 * (8 % - 4 %)

= 4 % + 1.50 * 4 %

= 4 % + 6 %

= 10 %. (Discount rate)

Note :- Beta of important competitor will be considered for the calculation of required return (discount rate) because it will be give reasonable more correct estimate / calculation for required return / discount rate for Hudson furniture.

Calculate the net present value (NPV) for the proposed investment plan of $ 10 Million using the above discount rate of 10 %. (Annual cash flows for eight years are $ 1.70 Million).

NPV = Present value of cash inflows - Present value of cash outflow.

= (1.7 Million * Cumulative present value factors for eight years at 10 % using present value table) - 10 Million

= 1.7 Million * 5.335 (approx) - 10 Million

= 9.0695 Million - 10 Million

= (-) 0.9305 Million.

As the net present value (NPV) for proposed investment plan (to enter in industrial furniture market) is negative, therefore, Hudson furniture shall not enter in industrial furniture market.