Question 3

You have just started a new position in the finance department of a large company and have identified what you believe to be is a valuable investment opportunity in an area of business unrelated to the company's existing operations.

The finance director is sceptical and has asked you to present an evaluation of the proposed investment for the consideration of the board.

You have gathered together the information below which you believe will allow you to undertake the evaluation of the investment:

• The average equity beta of firms in the same area of business as the proposed investment is 2.5, their average debt to equity ratio is 1:3, and they can borrow at the risk-free rate
• The company can also borrow at the risk-free rate which is 4%
• The market risk premium is 3%
• You believe the debt capacity of the proposed investment to be 40%
• Corporation tax is 30%

You expect that the proposed investment will generate post-tax cash flows of 8 million per year over 3 years and that the investment outlay required will be 15 million.

Required:

a) Calculate the Net Present Value (NPV) of the proposed investment using the adjusted Weighted Average Cost of Capital (WACC) method and advise the financial director as to whether the investment should go ahead.

b) Explain why the adjusted Weighted Average Cost of Capital (WACC) method has been used to evaluate the proposed investment above and discuss under what circumstances it is appropriate to use the Adjusted Present Value (APV) method for project evaluation.