Compute npv of investments using cost of capital

Question

Question 1.  The Saltinero Company is considering two investments. The firm’s cost of capital Is 12% and the risk-free rate is 7%.

A. Compute the NPV of the 2 investments using the firm’s cost of capital. Identify the preferred investment.

	Investment A			Investment B
Year	Projected cash Flow	PV		Projected Cash Flow	PV
0	-1,000	-1,000		-1,000	-1,000
1	600	536		700	625
2	600	478		600	478
3	600	427		500	356
4	600	381		400	254
Rr =	12%
	NPV	822	>		713

Since NVP of Project A is higher than Project B, A should be chosen.

B. Compute the NPV of the 2 investments using the certainty-equivalent approach. Identify the preferred investment.

	Investment A			Investment B
Year	Certainty Equivalent Cash Flow			Certainty Equivalent Cash Flow	PV
0	-1,000	-1,000		-1,000	-1,000
1	400	357		600	536
2	400	319		500	399
3	400	285		400	285
4	400	254		300	191
Rf =	7%
	NPV	215	<		410

Since NVP of Project A is lower than Project B, B should be chosen.

Question 2: Use the data for Saltinero Company (above). The beta of Investment A is 1.0, and the beta of B is 1.5. The market risk premium is 6 percent. Compute the NPV of the two investments using the risk-adjusted discount rate approach. Identify the preferred investment.

Question 3: Suppose Firm A’s levered beta is 0.75, its D/E ratio is 0.62, and its tax rate is 34 percent. Calculate its unlevered beta.

Question 4: Suppose the 10-year Treasury rate is current 3.54 percent. You analyze your firm’s financial ratios and determine that it is most similar to BB-rated firms, which currently have a spread over the 10-year Treasury of 400 basis points. Calculate your firm’s cost of debt.

Question 5: Firm B expects to pay a dividend next year of $4 per share and that its dividend will grow at a constant rate of 5 percent indefinitely into the future. Firm B’s stock price is currently $25 per share. Use the dividend discount model to calculate the cost of equity.