What is the appropriate discount rate that should be used

Question

XentiaTechnologies Group (XTG) is considering investing in developing new 4D television technology. The CEO of XTG, Ms Jane Smith, has appointed you to evaluate the proposal for the board. If the new project goes ahead it is expected that it be operational at the beginning of year 2 (with the first revenues generated by the end of that year). Once the new project is operational it will render the company's existing 2D technology project obsolete. The new project is then expected to have an operating life of six years.

To assist you in evaluating the project the following information has been prepared:

Existing 2D technology project:

Constant annual earnings before depreciation and taxes (EBDIT)    $400,000

Annual depreciation expense on equipment                                      $0

(Equipment fully depreciated)

Annual working capital balance                                                          $200,000

Expected salvage value of equipment if rendered obsolete              $0

 

New 4D technology project:

New equipment outlays (immediate)                                                  $10,000,000

Expected constant EBDIT                                                                  $3,800,000

(In the first year of operation)

Annual depreciation rate on equipment (straight line)                        10% p.a.

Expected salvage value of equipment at the end of the project        $3,500,000

Working capital requirement (once project is operational)                 $300,000

 

Additional Information:

1. Company tax rate is 30%
2. Xentia is financed with $25 million in market value of debt and $50 million in market value of equity.
3. Xentia has a beta of 1.6.
4. Revolutionary Technology Corporation (RTC) is currently using technology that is similar in risk profile to the new 4D project.
5. RTC is financed with $40 million in market value of debt and $40 million in market value of equity.
6. RTC has a beta of 1.75
7. Xentia borrows debt capital at a cost of 8% p.a. compounded semi-annually
8. The long term market risk premium (including franking credits) is 9.75% p.a.
9. The current yield on Commonwealth Bonds is 4.25% p.a.
10. Xentia operates in an imputation tax system.

Required:

i) What is the appropriate discount rate that should be used to evaluate the project?  Explain your decision.                                                    ii) Calculate the NPV of the project. Present the cashflows used in the NPV calculation in a table.                                                                      iii) Advise whether you should recommend the project. Explain your decision.