Question 4:

Hampton Roads, Inc., is a publicly traded company, which makes distilling equipment.It is a fairly stable company, with a beta of 0.75 and has been very profitable given the growth in the craft distilling industry. It is considering a new venture in a different, but related, industrymaking vessels for craft brewing.

The new project will have start-up costs (at t=0) of $60,000,000.The new investment is projected to have cash flows in its first year of only $1,000,000 as it 'gets to know' the industry. In its second year of operations, Hampton Roads projects cash flows of $10,000,000, and in its third year of $15,000,000. Management forecasts after year 3 indicate cash flow will grow at 10% for three years, then 2% in perpetuity.

Although this is a new venture for Hampton Roads, it has looked to similar projects for other companies which it believes aresimilar in risk to its new venture.

Historically, these projects' cash flows have been somewhat correlated with the market, at a correlation coefficient of 0.4.The standard deviation of the new venture's annual cash flows is estimated to be 30%. The risk-free rate is 3%.The market portfolio's expected return is 8%, and the standard deviation of the market's return is 15%.

a) What is the risk-adjusted, appropriate rate to use for Hampton Road's new venture?

b) After completing your analysis, answer:

b.i) What is the value of the new project in $?

b.ii) Should Hampton Roads go ahead with the project? Yes or No

c) At a recent meeting of top management, someone notes that because this project is in a new industry, it should be considered substantially riskier and, consequently, a higher discount rate would be appropriate.Comment.