The NNV Company is a new venture, which is evaluating its first business project. The proposed project’s expected (unlevered) operating cash flow is $ 1,100,000 per year. As NNV is a new entrant in the industry and is not sure about the proper discount rate of cash flow, it has to use that of its competitor - Company EST - as a benchmark. EST’s business is of approximately the same risk as NNV. EST’s debt-equity-ratio is 0.4 while its stock return is 12%. EST’s debt is risk-free. The cost of NNV’s project is $ 4,000,000. It plans to borrow $ 1,000,000 (i.e. risk-free debt) from bank to finance the project. The remaining cost is paid by equity holders (i.e., internal capital). The risk-free interest rate is 6%. The corporate tax rate is 50%.
i) What is the expected return of (unlevered) asset for NNV?
ii) What is the present value of NNV’s project? and the net present value?
iii) What is the debt-equity ratio after NNV undertakes the project?
iv) Based on the result of iii), work out the expected return of levered asset and WACC.
v) Using the WACC in iv), compute the present value of project again and verify that it is consistent with the result of ii).
vi) Using the expected return of levered asset, compute the present value of project and verify that it is consistent with the above results.