Question

Neon Corporation’s stock returns have a covariance with the market portfolio of .0385. The standard deviation of the returns on the market portfolio is 20 percent, and the expected market risk premium is 9.5 percent. The company has bonds outstanding with a total market value of $55.2 million and a yield to maturity of 8.5 percent. The company also has 4.70 million shares of common stock outstanding, each selling for $25. The company’s CEO considers the current debt–equity ratio optimal. The corporate tax rate is 40 percent, and Treasury bills currently yield 5.4 percent. The company is considering the purchase of additional equipment that would cost $42.2 million. The expected unlevered cash flows from the equipment are $12 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 stock	covariance/variance of market return	.0385/(20%)^2	0.9625
cost of equity	risk free rate+(market risk premium)*beta	5.4+(9.5)*.9625	14.54
after tax cost of debt	YTM*(1-tax rate)	8.5*(1-.4)	5.1
Market value of debt	bonds outstanding *market price		55.2
market value of equity	shares outstanding *market price	4.7*25	117.5
total value of company	55.2+117.5		172.7
WACC IN %	(weight of debt*after tax cost of debt)+(weight of equity*cost of equity)	(55.2/172.7)*5.1 + (117.5/172.7)*14.54	11.52
Year	0	1	2	3	4	5
cost of additional equipment	-42.2
cash flow		12	12	12	12	12
net operating cash flow	-42.2	12	12	12	12	12
present value of net operating cash flow = net operating cash flow/(1+r)^n r = 11.52%	-42.2/1.1152^0	12/1.1152^1	12/1.1152^2	12/1.1152^3	12/1.1152^4	12/1.1152^5
present value of net operating cash flow = net operating cash flow/(1+r)^n r = 11.52%	-42.2	10.76040172	9.648853768	8.652128558	7.75836492	6.956927
net present value = sum of present value of cash flow	1.58