Question

Anna is a Vice President at the J Corporation. The company is considering investing in a new factory and Anna must decide whether it is a feasible project. In order to assess the viability of the project, Anna must first calculate the rate of return that equity holders expect from the company stock. The annual returns for J Corp. and for a market index are given below. Currently, the risk-free rate of return is 1.2% and the market risk-premium is 2.4% Year J Corp. Return (%) Market Return (%) 1 -4.32 -2.10 2 16.30 8.21 3 24.12 12.12 4 16.12 8.12 5 -33.72 -16.80 6 31.64 15.88 7 8.84 4.48 8 26.00 13.06 9 10.08 5.10 10 18.30 9.21 11 -9.70 -4.79 12 -17.72 -8.80 Now that Anna has determined an appropriate rate of return for J Corp.'s stock, she must calculate the firm's Weighted Average Cost of Capital (WACC). There are currently 52.4 Million J Corp. common shares outstanding. Each share is currently priced at $17.65. As well, the firm has 4,000 bonds outstanding and each bond has a face value of $10,000, a yield to maturity of 3.21% and a quoted price of $10,121.20. J Corp.'s tax rate is 30%. J Corp. has no preferred shares outstanding. Refer to Questions 2 and 3. The land for the factory will cost $610,000. The factory will cost $2,920,000 to build and construction will take two years with construction costs payable in equal installments at the start of each year. The factory will operate for 20 years. At the end of its 20 year lifespan, the land can be resold for $230,000. There is a 70% probability that the factory's net operating cash flows will be $513,459; however, there is a 30% chance that net cash flows will only be $235,719. You may assume that net operating cash flows are received at the end of each year. a) What are the Expected net operating cash flows per year? Round your answer to 2 decimal places) b) What is the Internal Rate of Return for the project? Round your answer to one one-hundreth of a percent) c) What is the Net Present Value of the project? Round your answer to 2 decimal places) d) Should Anna recommend that the J Corporation build the factory?

Answer 1

	Return on Equity
	Risk Free rate	1.20%	Rf
	Market Risk Premium	2.40%	Rm
Year	J Corp. Return (%)	Market Return (%)
1	-4.32%	-2.10%
2	16.30%	8.21%
3	24.12%	12.12%
4	16.12%	8.12%
5	-33.72%	-16.80%
6	31.64%	15.88%
7	8.84%	4.48%
8	26.00%	13.06%
9	10.08%	5.10%
10	18.30%	9.21%
11	-9.70%	-4.79%
12	-17.72%	-8.80%
	Equity Beta = Covariance (Equity returns, Market Returns)/Variance(market Returns)
	Equity Beta = (Beta)	1.833	=COVAR($B$9:$B$20,$C$9:$C$20)/VAR(C9:C20)
	Return on Equity using Capital Asset Pricing Model
	Re = Rf + Beta*Rm
	Re=	5.60%
	WACC Calculations
	Shares Outstanding	52.4	Mn
	Price per share	17.65	$
	Market value of Equity	924.86	=# of Shares * Price
	Number of Bonds	4000	Units
	Bond Price	10,121.20	$
	Debt	40,484,800	$
	Debt =	40.48	Mn $
	Cost of Debt	3.21%	Current Yield
	Tax Rate	30%
	WACC = Equity/(Equity+Debt)*Cost of Equity + (Debt*(1-tax rate)/(Equity+Debt))*Cost of Debt
	WACC =	5.46%

Cost of Land	610,000
Factory Construction	2,920,000	Over 2 year, payable at start of year
Net Operating CF	Probability	Expected Value=CF*Probability
513,459	70%	359,421.30
235,719	30%	70,715.70
Net Expected Cash flow each year		430,137.00

Cash Flow	1	2	3-21	22
Cost of Land	(610,000)			230,000
Factory Construction	(1,460,000)	(1,460,000)
Net Expected Cash flow each year			430,137.00	430,137.00
Total CF	(2,070,000)	(1,460,000)	430,137	660,137

IRR = Using Excel formula IRR	9.85%
NPV @ WACC = Using Excel formula NPV	$1,433,323.75
Given IRR>>WACC and it’s a NPV positive project, it makes sense to build the factory