The COO, remembering her financial management class, is skeptical of using the WACC to determine the discount rate for capital budgeting purposes. Even though the investment is completely within the scope of the firm's business and does not present any new risk profile, she thinks the CAPM should be used to determine an appropriate discount rate. Since this firm is not publicly traded (and therefore has no beta) you decide to use the average of the betas of three publicly-held, competing firms to calculate a proxy beta for this company.
Firm 1: 1.25; Firm 2: 1.3; Firm 3: 1.4
According to the CAPM, what should the discount rate be? Assume the risk free rate is the current 10-yr T-bill yield (which you will need to obtain). For the market return use 8%. Indicate what risk-free rate you used and how you found it, and round your discount rate to one decimal place.
Does the COO's project have a positive or negative NPV at the discount rate calculated via the CAPM? Use the following assumptions:
Year Operating Cost Savings (pre-tax)
1 57,000
2 49,000
3 47,000
4 45,000
5 42,000
6 31,000
Depreciation: 5 year, straight line, no salvage value.
Disposition: The machine is projected to be worthless at the end of six years and will cost $5,000 to dispose.