Question

Corporate Financial Management:

3.FBA is a food processing firm that wishes to setup a small ice-cream business. The new business is expected to have a net cash flow if $50,000 in its first year. The cash flows are projected to grow at a high rate of 20% until the end of year 3, and thereafter at a rate of 3% per year in perpetuity. The project will be all-equity financed, the initial investment is $500,000.

(a)        If the appropriate discount rate is 12%, should FBA undertake the project?

(b)        The in-house business analyst suggests to benchmark the discount rate with Gelateria, a competing ice-cream maker. Gelateria does not have debt and has a beta of 1.50. If the market risk premium is 8% and risk-free rate is 3%, should FBA undertake the project?

(c)        The in-house business analyst is confident about the first three years estimated cash flows but is skeptical on the 2% long-term growth rate. What is the NPV if the long-term growth rate is zero using the discount rate provided in part (a)?

Answer 1

Initial Investment = 500,000
The Cash flow in Year 4 = 50000*(1+20%)^2*(1+3%) = 74160
a) Terminal Value = cash flow in year 4 /( rate - Growth) =74160/(12%-3%) = 824000
NPV = PV of All cash Flows - Initial Investment = 50000/(1+12%) +50000*(1+20%)/(1+12%)^2 + 50000*(1+20%)^2/(1+12%)^3+824000/(1+12%)^3 - 500000 = 230229.59
Yes FBA should undertake the project because NPV is positive

b) Cost of equity = Risk free rate + beta *(Market return - Risk free Rate) = 3%+1.50*(8%-3%) =10.5%
Terminal Value = cash flow in year 4 /( rate - Growth) =74160/(10.5%-3%) =988800
NPV = PV of All cash Flows - Initial Investment = 50000/(1+10.5%) +50000*(1+20%)/(1+10.5%)^2 + 50000*(1+20%)^2/(1+10.5%)^3+988800/(1+10.5%)^3 - 500000 = 380612.60
Yes FBA should undertake the project because NPV is positive

c) if growth is 0
then Terminal Value = cash flow in year 4 /( rate - Growth) =74160/(12%-0%) =618000
NPV = PV of All cash Flows - Initial Investment = 50000/(1+12%) +50000*(1+20%)/(1+12%)^2 + 50000*(1+20%)^2/(1+12%)^3+618000/(1+12%)^3 - 500000 =83602.86
Yes FBA should undertake the project because NPV is positive

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