Since both companies have the same risk profile, you can assume that both companies have the same cost of capital
The T-bill rate is a proxy for the risk-free rate
Use CAPM to estimate the cost of equity.
Case Study II
CCC Company has nine million shares of common stock outstanding and 150,000 7.5 percent semi-annual bonds outstanding. The firm’s common stock is currently selling at a price of 37 dollars per share. CCC has an equity beta of 1.25. As for debt, the firm’s outstanding bonds are quoted at 95 percent of par value and have 16 years to maturity. The par value on each bond is 1,000 dollars. Market risk premium is 8 percent. T-bills are offering a yield of four percent.
HHH are considering the investment in a new project. The new investment project has the same level of risk as that of the firm’s average risk project. The project has an economic life of five years. The new project requires an initial investment of two million dollars in machinery. The project’s sales are forecasted to be 1.25 million dollars per year for the next five years. The fixed assets will be depreciated down to zero over the life of the project. The firm applies the straight-line depreciation method. Costs pertaining to the new project are expected to be 27.5 percent of sales. HHH will also need to make an immediate investment of 100,000 dollars in net working capital. Additional net working capital will be recovered in full at the end of the project’s life.
HHH is the main competitor of CCC and both have similar risk characteristics. Both companies have a tax rate of 34 percent.
– Should HHH proceed with the project?
– How sensitive is NPV to a one percent change in the project’s revenue?
– Calculate the project’s (financial) break-even revenue.
