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A project requires an initial investment in equipment of $760,000 immediately (t=0) and is expected to produce sales revenue of $697, 000 the first year;

A project requires an initial investment in equipment of $760,000 immediately (t=0) and is expected to produce sales revenue of $697, 000 the first year; this revenue will increase by 4.5% per year over the next four years. Manufacturing costs are estimated to be 67% of the sales. The project demand analysis, which was done last year, cost $235,000. The asset can be depreciated on a straight-line basis over five years to a zero salvage value. The corporate tax rate is 36%. The project requires an investment in working capital. Specifically, at the beginning of the project (t=0), $45,000 of working capital is required; thereafter, working capital is projected to be 6.0% of revenue. The investment in working capital will be recovered at the end of the fifth year. At the end of the 5th year, the company plans to sell the equipment for $18,900.

To calculate the cost of capital for this project, the firm is going to use the following companies as comparable firms.

Beta

Debt

Equity

XOM

1.00

11.63B

403.10B

CVX

1.22

20.02B

224.24B

Assume that the market risk premium is 6%, the risk free-rate is 5%, and all debt is risk free, static and perpetual, and that the CAPM holds. The firm is going to finance the project with all equity.

  1. Determine the cost of capital for this project.
  1. Given the project described above, should the investment be undertaken?

c. Now suppose the firm can expand the value of the project by 50 percent at the end of year 1 with an additional investment of $500,000. Further, the firm has the option to sell the asset to another firm at the end of year 1 for $600,000. If the returns of the project have a standard deviation of 25% and the risk-free rate is 5%, what is the value of the project including these options? Use a binomial tree with 2 steps to determine the value (you can only expand or sell at the end of year 1, not before or after).

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