Question

Question 4 (old exam question)

You just landed a job as the chief financia

l officer at Social Network Incorporated.

When you start working you first look closer at

the financial statements of the firm. You

see that the company is fully equity financed.

You also notice that a

ssets have a value of

$40,000,000 and that the asset beta is 0.6. The

firm’s stock had a return of 12%

last

year,

but you do not expect this to continue. This can be compared to a 9% market return

(which in contrast you expect

to continue) and risk free rate

of 2%. Corporate taxes are

30%.

You are asked to calculate whether starting a new project called ‘Facebook’ will be a

good idea. This is a social netw

orking project, just like most

other projects

that your firm

engages in. The start-up costs of the pr

oject is $1,000,000 and the marketing team

estimates that it can be a success for at least 15 years, after which the firm will stop the

project. The initial investment

in the project is to depreciated to a salvage value of

$250,000 – but actually you expect to be able

to sell the project to Google for only

$150,000 in 15 years time. It is estimated that

this new project will generate an annual

income of $75,000, while operating costs wi

ll be $15,000 per year. The project also

requires an increase in working capital, main

ly IT interns, of $80,000 which is freed up

again at the end of the project.

Calculate whether starting project ‘Facebook’

is a good idea through the following steps

a)

What is the expected return on Social Ne

twork Incorporated over the next year?

b)

What is the weighted average cost of capital for the firm?

c)

Calculate the net present va

lue of starting the project.

d)

What if taxes are now 40%? Will this a

ffect your NPV calculation in part c)?

Will it affect the cost of capital of your fi

rm? There is no reason to calculate in

this part, a brief explanation will do.

Answer 1

A) Expected Return of social networking inc. :-

Here,

R​​​​​​f = risk free rate

ERM = expected market rate

= 6.2%

B) WACC = cost of equity, since it is a fully financed equity firm with no debt.

K​​​​e

= 8%

C) NPV of starting the project :-

Initial outlay (1,000,000)

Annual Income. 75,000

Operating cost. (15,000)

Increase in 80,000

Working Capital

After- tax salvage. 1,05,000

Value:(less150000*30%)

2,45,000

Less: tax@30%. 73,500

Total cash = 1,71,500

Inflow after tax

Discounting factor @6.2%

=

= 9.587

PV of expected cash flows = 171500*9.587= $1,644,187.097

NPV= 1644187.097-1000000

= $6,44,187.09

D)Yes, 40% tax will affect the NPV calculation since cash flows and salvage value is taken after tax. Whereas it will not affect the cost of capital since it is fully equity financed and therefore not tax deductible.