A real investment opportunity costs £1m. It generates an expected risky revenue cash flow of £100,000 each year, but requires annual risk free maintenance costs of £10,000. Assume these cash flows continue indefinitely. Finally, the project gives you access to cheap government financing below the current market rate. You estimate that the financing benefits have a net present value of £50,000. The risk free interest rate is 5%, and the expected rate of return on the market index is 12%. The beta-risk of the revenue stream is 0.75.

a) Work out whether the project is worthwhile. State all additional assumptions made.

b) You are a bit uncertain about the beta-estimate for the revenue stream. The equity of a firm in

1)

discount rate of risky cash flow = 5% + (12% - 5%) * 0.75 = 10.25%

PV of risky cash flow = 100,000 / 10.25% = 975,609.76

PV of risk free maintenance cost = 10,000 / 5% = 200,000

NPV of the project = PV of risky cash flow + PV of cheap government financing – Initial cash outlay - PV of risk free maintenance cost = 975,609.76 + 50,000 – 1,000,000 – 200,000 = -174,390.24

The project is not worthwhile due to its negative NPV.

2)

cost of equity = 5% + (12% - 5%) * 2 = 19%

debt-equity ratio of 1 implies 50% debt and 50% equity. Therefore,

discount rate of risky cash flow = 50% * 5% + 50% * 19% = 12%

We can see right here that the project will not produce a positive NPV because the risky flows will be discounted at a higher rate (thus yielding a lower PV) while the PVs of other components of the project remain the same. Calculation is essentially the same as the one above if you wish to carry it out.