Asked by Bridget Stokes on Jun 23, 2024
Verified
Muller, Inc., manufacturer of cardboard boxes, is considering taking on a new line of quality stationery, a related but very different field than cardboard boxes. Management has prepared a, six-year forecast for the project planning to reevaluate the venture after that time. The forecast anticipates that the project will cost $2 million to start after which it will generate $500,000 in each of the next six years. To be conservative a $200,000 shut down cost at the end of the sixth year has also be forecast. Muller's beta is 1.2, but Nugent Paper, a rival stationery manufacturer that does nothing else, is known to have a beta of 1.6. The return on an average stock is 9%, and the risk free rate is 5%. Muller's cost of capital is 8%.
a. What is the NPV of the stationery project if Muller uses the traditional cost of capital method for calculating NPV?
b. Assume that Nugent Paper is a pure play company for Muller's project. What is the NPV of the project using Nugent Paper and the pure play method?
c. What should Muller do? Why?
Pure Play Method
An approach in finance where investments are made in companies that specialize in a single line of business or sector to achieve specific exposure.
Beta
A measure of a stock's volatility in relation to the overall market; a beta above 1 means the stock is more volatile than the market, while below 1 means less.
NPV
Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
- Compute and assess the Net Present Value (NPV) of projects across various scenarios employing probabilistic forecasts.
- Acknowledge the criticality of adjusting for risk in capital budgeting and employing correct discount rates.
- Assess the usefulness and technique of employing pure play and the security market line to estimate returns adjusted for risk.
Verified Answer
BM
Babis MagouliasJun 26, 2024
Final Answer :
$(000)
a. CFo = -2,000; C01 through C05 = 500; C06 = 300; NPV: I=8
NPV = $185.406
b. k = kRF (kM - kRF)b = 5+(9-5)1.6=11.4
CFo = -2,000; C01 through C05 = 500; C06 = 300; NPV: I=11.4
NPV = ($13.529)
c. Muller should reject the project based on the current forecast. The positive NPV at Muller's own cost of capital is misleading because it implicitly assumes the project's risk is similar to Muller's. The pure play analysis indicates that isn't the case. The project is considerably more risky and using the SML to adjust for that risk through the interest rate yields an unacceptable NPV.
a. CFo = -2,000; C01 through C05 = 500; C06 = 300; NPV: I=8
NPV = $185.406
b. k = kRF (kM - kRF)b = 5+(9-5)1.6=11.4
CFo = -2,000; C01 through C05 = 500; C06 = 300; NPV: I=11.4
NPV = ($13.529)
c. Muller should reject the project based on the current forecast. The positive NPV at Muller's own cost of capital is misleading because it implicitly assumes the project's risk is similar to Muller's. The pure play analysis indicates that isn't the case. The project is considerably more risky and using the SML to adjust for that risk through the interest rate yields an unacceptable NPV.
Learning Objectives
- Compute and assess the Net Present Value (NPV) of projects across various scenarios employing probabilistic forecasts.
- Acknowledge the criticality of adjusting for risk in capital budgeting and employing correct discount rates.
- Assess the usefulness and technique of employing pure play and the security market line to estimate returns adjusted for risk.