Question

Neon Corporation’s stock returns have a covariance with the market portfolio of .0455. The standard deviation of the returns on the market portfolio is 20 percent, and the expected market risk premium is 7.9 percent. The company has bonds outstanding with a total market value of $55.04 million and a yield to maturity of 6.9 percent. The company also has 4.54 million shares of common stock outstanding, each selling for $24. The company’s CEO considers the current debt–equity ratio optimal. The corporate tax rate is 40 percent, and Treasury bills currently yield 3.8 percent. The company is considering the purchase of additional equipment that would cost $42.04 million. The expected unlevered cash flows from the equipment are $11.84 million per year for five years. Purchasing the equipment will not change the risk level of the company.

  

Calculate the NPV of the project.

Answer 1

Beta of company	covariance between stock return and market return/ variance of market	.0455/.04	1.14
Variance of market return	square of standard deviation	20%^2	0.04
covariance between stock return & market return			0.0455
Required rate of return on equity Using CAPM	risk free rate+(market risk premium)*beta	3.8+(7.9)*1.14	12.81
after tax cost of bonds	YTM*(1-tax rate)	6.9*(1-.4)	4.14
WACC
source		Value	Weight = Individual value/total
Bonds		55.04	0.3356098
common stock	4.54*24	108.96	0.6643902
total		164	WACC = sum of weight* cost of source
Year	cash flow	present value of cash flow = cash flow/(1+WACC)^n WACC = 10.22%
0	-42.04	-42.04
1	11.84	10.74215
2	11.84	9.746101
3	11.84	8.842407
4	11.84	8.022506
5	11.84	7.27863
NPV = sum of present value of cash flow		2.59
NPV is positive so it should be purchased