The Guru Company is considering a new project as part of its 2001 capital budget. Today's date is January 1, 2001. The project has the following characteristics:
i. If the project is adopted, new sales will begin immediately. For purposes of analysis, the company assumes that cash flows during the year occur at year-end. New sales generated by the project each year will be either 300 million or 500 million. The probability of each outcome is .50. Variable cost is estimated to be 40 percent of sales. Annual fixed cost, not including depreciation, allocated to the project will be 50 million per year. Such costs are often referred to as "allocated costs," "allocated fixed costs," or "allocated overhead." None of the allocated fixed costs are directly attributable to the new project.
ii. Guru's tax rate is 30 percent.
iii. The expected life of the project is five years.
iv. The investment required for the project has two components. (1) An investmnet of 400 million is required for equipment. The purchase price of the equipment is to be paid immediately. The equipment will be depreciated over a five year life, on a straight line basis, to zero book value. (2) An investment in net working capital. At beginning of each year, current assets minus liabilities will be 40% of expected sales fo rthe year. The working capital is expected to be fully recovered at the end of the project's life.
v. The after-tax required return (i.e., cost of capital) on the project is 10 percent per year.
a. Should Guru undertake this project? (Hint: In calculating the project's NPV, use expected cash flows.)
b. What will happen to the total market value of Guru's common stock at time t=0 if the project is accepted?