Question

You have been asked to analyze whether Proxima Inc, a computer manufacturer, should invest in producing new software.

•           Proxima will have to invest $ 5 million if it wants to commercially develop the software, and this investment will be depreciated straight line over four years to a salvage value of zero at the end of the 4th year.

•           Based upon a market study, Proxima concludes that it can generate revenues of $6 million every year for the next 4 years; operating expenses (other than depreciation) are expected to be 60% of revenues each year.

•           Proxima has an unlevered beta of 0.90 but the unlevered beta for computer software companies is 1.50. The market value of equity for Proxima is $ 80 million and the market value of debt is $ 20 million. Proxima plans to maintain this debt to capital ratio for this project. The cost of debt for Proxima is 7%.

•           The riskless rate is 5% and the market risk premium is 4%. The tax rate is 21%.

What is the net present value of this project? Should Proxima Inc. invest in producing new software?

Answer 1

	we have to first compute Weighted average cost of capital
	Compute of required rate of equity based on CAPM
	Required rate = risk free rate + Market premium * beta
			=(5%+4%*1.5)
			11.00%
	Post tax cost of debt =				=7%*(1-21%)
					5.530%
	Computation of WACC =				=(20/100)*5.530%+(80/100)*11%
	Computation of WACC =				9.906%
	Computatio of annual operating cash flow
i	Revenue		6,000,000
ii	Cost @ 60%		3,600,000
iii	Annual depreciation	=500000/4	1,250,000
iv=i-ii-iii	Profit before tax		1,150,000
v=iv*21%	Tax @ 21%		241,500
vi=iv-v	Profit after tax		908,500
vii=vi+iii	Annual cash flow		2,158,500
	Computation of present value
	year	Initial investment	Annual cash flow	Total cash flow	PVIF @ 9.906%	present value
	0	-5000000	-	(5,000,000)	1.0000	(5,000,000)
	1		2,158,500	2,158,500	0.9099	1,963,951
	2		2,158,500	2,158,500	0.8279	1,786,937
	3		2,158,500	2,158,500	0.7532	1,625,878
	4		2,158,500	2,158,500	0.6854	1,479,335
						1,856,100
	Therefore present value=					1,856,100
	Since NPV is positive therefore project should be accepted