Risk-free rate R_f

For Risk-free rate R_f in this exam, use the Yield (using the asked price) of the following 10-year bond (price as of June 4, 2020, this is the settlement date):

maturity

Coupon

Bid Price

Asked Price

Yield to Maturity

5/15/2030

6.250%

152.18

152.19

Question 1

(a) Define and briefly explain the NPV, IRR and Payback methods of project evaluation, discussing their relative merits and demerits.

A MNC is considering expansion in South America.The project entails setting up a factory which will be developed in two phases.The first phase must be initiated now.Following phase I, the company can undertake a major expansion in the fourth year.The cost of capital for the company is 20%.Tax rate is 30%

Phase I: The first phase will generate the following income for 5 years for an investment of $350m now (EBT is earnings before taxes):

Item/Year

T=0

T=1

T=2

T=3

T=4

T=5

Capital Investment

300

Working capital

30

EBT

50

100

200

250

300

Phase II:The second phase will start at T=4. The company expects the following cash flows for the second phase (EBT is earnings before taxes):

Item/Year

T=4

T=5

T=6

T=7

T=8

T=9

Capital Investment

1500

Working capital

500

EBT

350

350

500

550

750

After year 9, the EBT continues at $750 for the next 6 years (until year 15), at the end of which of the factory will be sold for $2000.

(a)What is the NPV of phase I? Should it be accepted?

(b) What is the NPV of Phase II?Should it be accepted?

(c)What is the total NPV, IRR and Payback Period of the combined project, including two phases?Would you accept the project by the NPV rule?

Obviously, there is significant amount of uncertainty about the expected cash flows from the major expansion in Phase II.Depending on how Phase I goes, the company will decide about Phase II - Expand or Not. The company estimates the annual standard deviation of expected cash flows of phase II is 40%.

(e) Is it correct to evaluate Phase II using the NPV rule?Briefly Explain

(f)What is the Option value of Phase II?Is the option value a more appropriate measure of the project's true worth?Would you accept the project by the Real Option valuation?