Question

Assume that Kimball Oil, a large user of natural gas, and Christie Hot Air Inc., a major explorer/producer of natural gas, have no debt in their capital structures and finance all their projects with cash. They are each considering an investment in wells to extract natural gas and are evaluating the NPV of their respective investments. The projects have identical cash flows (including initial investment and expected future cash flows). Each of the companies calculates that the NPV of the project would be $1 million at an opportunity cost of capital of 5.4%, and -$1.1 million if the opportunity cost is 8%. Kimball Oil has a beta of 1.2, and Christie Hot Air has a beta of 0.68. The E(Rm) is 7% and the risk-free rate is 2%. What would you recommend to Kimball and Christie about whether they should proceed with the proposed investment? Explain. It might not hurt to think of this question in the context of the material on pages 4-6 of the Class 8 notes (Company versus Project Cost of Capital.)

Answer 1

According to Captal asset pricing model (CAPM):-

Expected return of Kimball Oil = Risk free rate + Beta * (Expected market return - Risk free rate)

= 2 % + 1.2 * (7 % - 2 %)

= 2 % + 1.2 * 5 %

= 2 % + 6 %

= 8 %

Expected return of Christie Hot Air = Risk free rate + Beta * (Expected market return - Risk free rate)

= 2 % + 0.68 * (7 % - 2 %)

= 2 % + 0.68 * 5 %

= 2 % + 3.4 %

= 5.4 %

Christie Hot Air should go for the proposed investment because the NPV of project of 1 Million is positive at opportunity cost of capital of 5.4 % which is also equal to its expected rate of return calculated above. In short, at expected rate of return of 5.4 % for Christie Hot Air, its NPV of project is positive. However, Kimball oil should not go for the proposed investment because at its expected rate of return of 8 % calculated above, The NPV of project is (-) 1.1 Million i.e., NPV is negative.

Conclusion :- Christie Hot Air must proceed with investment proposal whereas Kimball oil must not proceed with such investment proposal.