Question

There are two risky investments, Chaser and Steady.

Chaser has two equally likely possibilities both with perpetual cash flows. It can have either a good state or a bad state. In the good state, cash flows start at £15m at the end of year one and grow at the rate of 4% every year while in the bad state, cash flows start at £12m at the end of year one and decline at the rate of 2% every year.

The cash flows of Steady will start at £24m at the end of the fourth year and remain at that level forever.

As a measure of the risk in each project the relevant beta of Chaser is 1.5 and of Steady is 0.5. The current base rate (i.e. risk free rate) is 3% per annum and the expected stock market return is 9% per annum. The investment costs are £98m for Chaser and £284m for Steady.

a) Which investment should be preferred according to the Net Present Value criteria?

b) If you could shut down the Chaser investment when the bad state occurs at zero cost, which investment should be preferred according to the Net Present Value criteria?

c) A large multinational is willing to buy the Chaser investment at any time. You are negotiating the price they should pay for it. What is the minimum price you must bargain for to ensure the Chaser investment is worth more than the Steady investment?

can calculations be shown as well

Answer 1

Answer to part (a)
Information:
Calculation of required rate of return
	Chaser	Steady
Risk free rate (Rf)	3.00%	3.00%
Market return (Rm)	9.00%	9.00%
Beta	1.5	0.5
Required Return rate (RR)	12.00%	6.00%
= Rf + (Rm - Rf) Beta
Calculation of NPV of Chaser
	Good State	Bad State
Cash Flow (Million)	£      15.00	£    12.00
Growth Rate	4.00%	-2.00%
Required Return rate (RR)	12.00%	12.00%
Cash Flow at DCFF (Million)	£    187.50	£    85.71
Possibility	0.5	0.5
Total Cash Inflow expected (Million)	£   187.50	£   85.71
Less:- Total Cash outflow (Million)	£      98.00	£    98.00
Net Present Value (Million)	£     89.50	-£   12.29
Calculation of NPV of Steady
Cash Flow (Million) perpectual start from 4th year end	£      24.00
Required Return rate (RR)	6.00%
Cash Flow at DCFF (Million) at end of 4th year	£    400.00
Total Cash Inflow expected (Million) today [DCFF/PVF]	£   316.84
Less:- Total Cash outflow (Million)	£    284.00
Net Present Value (Million)	£     32.84
At Net Present Value criteria, Steady Investment is preferrable, beacause in Chaser investment there is uncertainity whether it is good state or bad state. If bad state happens, there would be loss in shareholder's wealth.

Answer to part (b)
If Investor could shut down chaser investment at zero cost when bad state occurs, he can enjoy good state and in part (a) we can see NPV is greater than Steady investment. So investor should chose chaser investment in this case.

Answer to part (c)
Chaser Investment Outflow (Million)	£      98.00
NPV of Steady (Million)	£      32.84
	£   130.84
If negotiated price is above than euro 130.84/- million, chaser investment is worth more than the seady investment.