Problem:
The management of firm A is considering starting a new project. The project needs an initial investment equal to $ 1,000,000. The risk of the project is identical to that of the firm’s current risky assets. The expected rate of return on new project is 15% annually, forever. The firm’s balance sheet (market values) prior to announcement of the investment project is as follows:
Risky Assets $5,000,000 Equity $ 4,000,000
Cash 1,000,000 Leverage 2,000,000
6,000,000 6,000,000
There are 100,000 shares outstanding. The beta of the firm’s stock is equal to 1.35; the beta of its debt is equal to 0.15. The risk-free rate is equal to 4%, and expected market risk premium is 7%.
Required:
a) Compute (1) the Beta of the firm, and (2) the Beta of the firm’s risky assets.
b) Compute the NPV of the new project. Ignore tax considerations.
c) Within the board of directors there is a discussion about optimal financing choice. The CFO prefers Leverage since this raises the firm’s profit per share, and, thus, the value of the shares. Do you agree with the CFO (ignore taxes!)?