Question

Neon Corporation’s stock returns have a covariance with the market portfolio of .0345. The standard deviation of the returns on the market portfolio is 25 percent, and the expected market risk premium is 8.8 percent. The company has bonds outstanding with a total market value of $55.13 million and a yield to maturity of 7.8 percent. The company also has 4.63 million shares of common stock outstanding, each selling for $23. The company’s CEO considers the current debt–equity ratio optimal. The corporate tax rate is 34 percent, and Treasury bills currently yield 4.7 percent. The company is considering the purchase of additional equipment that would cost $42.13 million. The expected unlevered cash flows from the equipment are $11.93 million per year for five years. Purchasing the equipment will not change the risk level of the company.

  

Calculate the NPV of the project. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

NPV

$

Answer 1

Answer: a. To calculate the NPV of the project, we first need to find the company's WACC. In a world with corporate taxes, a firm's weighted average cost of capital equals:

R_WACC = (B/B+S)(1-TC)R_B+(SI(B+S))R_S

The market value of the company's equity is:

Market value of equity = 4,630,000($23)

Market value of equity = $106,490,000

So, the debt-to-value ratio and equity-to-value ratio are

Debt-to-value = $55,130,000 / ($55,130,000 + 106,490,000)

Debt-to-value = .0.3411

Equity-to-value = $106,490,000 / ($55,150,000 + 1 06,490,000)

Equity-to-value = 0.6588

Since the CEO believes its current capital structure is optimal, these values can be used as the target weights in the firm's weighted average cost of capital calculation. The yield to maturity of the company's debt is its pretax cost of debt. To find the company's cost of equity, we need to calculate the stock beta.

The stock beta can be calculated as: ?-.0345 / .25²

? = .55

Now we can use the Capital Asset Pricing Model to determine the cost of equity.

The Capital Asset Pricing Model is: R_S = RF + ?(RM-RF)

R_S = 4.7% + .55(8.8)

R_S = 9.54%

Now, we can calculate the company's WACC, which is

R_WACC = (B/B+S)(1-TC)R_B+(SI(B+S))R_S

R_WACC = 0.3411(1-0.34)(.078) + 0.6588(.954)

R_WACC = 0.0803, or 8.03%

Finally, we can use the WACC to discount the unlevered cash flows, which gives us an NPV of:

NPV = -$42,130,000+ $11,930,000 (PVIFA 8.03%,5)

NPV = $5473404.08