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

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?

Expert Solution

	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

jeff jeffy answered 1 year ago

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