A company has three investment opportunities and wishes to use expected net present value (ENPV) to evaluate the projects. The Mars and Mercury outcomes have been provided, Venus requires estimation.  Details as follows:

 

Project	Mars	Venus	Mercury
Year 0		Investment £5m
Year 1		Cash flows  negative £2m probability 0.3   Cash flows £8m  Probability of 0.7
Year 2		If year 1 cash flows are negative £2m: Year 2 cash flows negative £3.14m, 0.25 probability and cash flows of £1.26m, probability of 0.75    If year 1 cash flows are £8m: 0.8 probability of £10m 0.2 probability of £6.27m
ENPV	£3.75 million	To be calculated	£2 million
Standard Deviation	£1.38m	To be calculated	£0.0m

 

Venus's cash flows are stated at their respective year 0, year 1 and year 2 levels.  The cost of capital is 12%.

 

Requirements:

 

1. Estimate the ENPV for Venus project                                          

 

1. Estimate the standard deviation for Venus project (with ENPV being the expected return)                                                                           

 

 

1. Provide a recommendation as to whether Mars, Venus or Mercury should be chosen based on their ENPVs and standard deviations.  Your justification should extend to discussion of the benefits of ENPV plus consideration as to why estimating the most likely outcome of an investment in isolation can be both limiting and give a false impression.

 

Part 

Expand Ltd (Expand) wish to diversify into a new service area.  Their existing beta is 0.9, based on their existing business risk and capital structure of 30% debt and 70% equity.  They have identified a proxy company already established in the new service area with a beta of 1.2 and capital structure of 40% debt with 60% equity. 

The risk free rate is 1.3% and the market risk premium is 5.6%.  The corporate tax rate is 20%.  Expand's pre-tax cost of debt is 5% and you are to assume there is no significant change to the capital structure as a result of this new investment.

 

Required:

 

Calculate the weighted average cost of capital for Expand's diversified investment.                            

                                                                                                            

 

Explain how the Security Market Line result from the Capital Asset Pricing Model can be used by firms to set an appropriate weighted average cost of capital, irrespective of differences in capital structure.