Aloha's capital structure consists of 30% debt (20-year, 8% annual coupon bonds, selling at par) and 70% equity (common stocks). The firm has an equity beta of 1.5. The risk free rate is 5% and the long-run average market return is 11%. The marginal tax rate of the firm is 40%. Assume that the CAPM holds and that the firm will not alter its capital structure should new external financing be needed.
Requirement:
Question 1: Judging by the NPV rule, should the firm undertake a project that requires an initial outlay of $1 million and is expected to generate a perpetuity of $100,000 per annum (what is the NPV)?
Question 2: How would your answer change if the firm had conducted an intensive, $400,000 feasibility study to assess the attractiveness of the new product prior to estimating the cash flows?
Note: Provide specific examples to support your answers.