Question
CIn order to satisfy future growth opportunities, COL is evaluating investing in one of two major projects; these projects will be called Project A and
CIn order to satisfy future growth opportunities, COL is evaluating investing in one of two major projects; these projects will be called Project A and Project B. In order to mitigate risk, COL has asked Rachel Consulting Limited to conduct some market research. Rachel Consulting is being paid $25m as a fixed fee for her expert consulting services.
Project A has an initial outlay of $150 million and Project B has an initial outlay of $85 million.
Project A will generate additional revenues of $45 million starting at the end of year 1 until the end of year 10. It will also incur additional working capital expenses of $1 million immediately, this working capital will be recovered at the end of the project.
Project B will generate additional revenues of $25 million starting at the end of year 1 until the end of year 10. It will also incur additional working capital expenses of $2 million immediately, this working capital will be recovered at the end of the project.
The operating costs of both projects will be 20% of the revenues from years 1 to 10. Both projects will be depreciated on a straight line basis over ten years to zero book value. COL has estimated that some assets involved in the upgrades can be sold at the end of year 10 respectively for $25 million (Project A) and $10 million (Project B). The tax rate is 30%. All cash flows are annual and are received at the end of the year. The cost of capital for both projects is 6%.
1. Calculate the FCFs for each project.
2. What is the NPV for each project?
3. What is the discounted payback period for each project?
4. What is the IRR for each project?
5. Assume that the risk of investing in these projects is higher than the overall risk of COL. What would happen to the discount rate and consequently NPV of the two projects if this was the case? Explain your answer.
6. Suppose that COL has a payback rule of 7 years. Based on all of your analysis, which project should be chosen? Justify your answer.
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