Question

Gilton Co. is evaluating a project with the following cash flows. The firm does not have any debt and all the required financing for the project is through stockholders.

Table 1: Cash flows of the project

Year	Cash flow (£)
	(45,000)
1	14,000
2	16,000
3	17,000
4	20,000

Table 2: Risk and Return

	Expected Return	Standard Deviation	Beta
Gilton Co.	?	30%	1.3
FTSE 500	13%	12%
Risk Free Asset	2%	0%

Using the provided information in Table 2 and assuming that CAPM holds:

1. Calculate the expected return of the firm.

2. Using the estimated expected return, evaluate the project using the following criteria (Table 3) and decide if you accept/reject project based on each criterion (the last column of table 3).

Hint: You can use excel to find out IRR of the project.

Hint: Consider the managers’ threshold for PB, DPP and PI.

3. Please provide NPV profile of the project.

Hint: Use excel to draw the graph and then paste in the word file.

Table 3: Project criteria

Criteria	Value	Managers’ Threshold	Accept/Reject
NPV
IRR
Payback Period (PB)		2.5 year
Discounted Payback Period (DPB)		4 year
Profitability Index (PI)		0.5

4. Considering estimated criteria, provide your insight about this project as an independent analyst. ( 5 marks)

EXEL CAN BE USED

Answer 1

a)

The required rate of return R(e) is calculated by CAPM model

R(e) = r(f) + Beta*(R(m) - r(f))

R(m) is the market return =13%

r(f) is the risk-free rate = 2%

Beta = 1.3

R(e) = 0.02+1.3*(0.13-0.02)

R(e) = 0.163= 16.3%

b) We calculate the NPV, IRR using excel

We discount the cash-flows by 16.3% to get NPV

Year	Cash flow (£)
	-45,000
1	14,000
2	16,000
3	17,000
4	20,000
NPV	606.5791771
NPV Formula	B2+NPV(16.3%,B3:B6)
IRR	16.94%
IRR Forula	IRR(B2:B6)

Payback period is the time taken in year for the cumulative cash-flows to become 0

Discounted Payback period is the time taken in year for the cumulative discounted cash-flows to become 0

We observe that sometime after year 2, cumulative cash-flows become 0

Sometime after year 3, discounted cumulative cash-flows become 0

Year	Cash flow (£)	Cumulative cash-flows	Discounted cash-flows	Cumulative discounted cash-flows
	-45,000	-45,000	-45000	-45000
1	14,000	-31,000	12037.8332	-32962.16681
2	16,000	-15,000	11829.3411	-21132.82576
3	17,000	2,000	10807.1151	-10325.71065
4	20,000	22,000	10932.2898	606.5791771
	Payback period (in years)	2.8824	Discounted payback (in years)	3.944514902

Profitability Index = PV of future cash-flows/Initial investment = 45606.58/45000 = 1.01348

Criteria	Value	Managers’ Threshold	Accept/Reject
NPV	606.58	0	Accept
IRR	16.94%	16.30%	Accept
Payback Period (PB)	2.8824 years	2.5 year	Reject
Discounted Payback Period (DPB)	3.94 years	4 year	Accept
Profitability Index (PI)	1.01348	0.5	Accept

NPV Profile

We find the NPV form different interest rates

Interest rate	NPV
1%	20,266
2%	18,601
3%	17,001
4%	15,463
5%	13,985
6%	12,563
7%	11,194
8%	9,876
9%	8,607
10%	7,383
11%	6,203
12%	5,066
13%	3,968
14%	2,908
15%	1,885
16%	897
17%	-59
18%	-982
19%	-1,875
20%	-2,739
21%	-3,575
22%	-4,385
23%	-5,169
24%	-5,928
25%	-6,664
26%	-7,377
27%	-8,069
28%	-8,740
29%	-9,391
30%	-10,023

Insights

All the criterion except payback period is acceptable. We have a positive NPV and an IRR greater than the expected return. Also, the discounted payback period is within the acceptable range. The profitability Index is well above the threshold. Hence, the project must be undertaken.