[Solution]Are the NPVs different? If so, why are they different, and does the difference affect the investment decision? Comment briefly

Section B: Question 3 [25 marks] The CEO of EG Inc. is always on the lookout for new opportunities. The company, a highly profitable conglomerate,…

Section B:
Question 3 [25 marks]
The CEO of EG Inc. is always on the lookout for new opportunities. The company, a highly
profitable conglomerate, currently consists of three divisions: Oil & Gas, Sportswear, and Car
Production. In a recent meeting with EG’s top-level management, the CEO enthused about a
recent documentary about asteroid mining and now wants EG to launch a Space Exploration
division to benefit from the potential she perceives in this sector.
Unfortunately, EG’s Chief Financial Officer (CFO) has fallen ill and you have been asked to
evaluate this potential space exploration project. In her excitement, the CEO wants to move
quickly, and she has provided you with the following financial projections:
Year 0 1 2 3
Sales ($m) 0 150 200 240
Net working capital ($m) 0 30 40 45
• Assume Costs of Goods Sold are 75% of Sales
• The project requires a $1,000m (=$1 billion) investment in a production facility
at t=0; assume a useful life of 25 years and linear depreciation (starting at t=1)
• The corporate tax rate is 30%.
• After t=3, assume that annual free cash-flows will grow at a rate of 3% in
perpetuity
Furthermore, the CEO tells you that EG currently has an equity cost of capital of 10%, a debt
cost of capital of 5%, and the company is targeting a debt-to-equity ratio of 1.5. Before
leaving your office, the CEO specifically instructs you to use EG Inc.’s WACC to value the
project.
Before starting your analysis, you notice that the CFO’s assistant has sent you a brief email
titled “You may find this useful.” The email contains the following table:
Company Industry Equity
Beta
Debt Beta D/E Constant
D/E ratio?
Esson Oil & Gas 1.41 0.35 1.31 Yes
WMB Car Production 1.83 0.34 0.83 Yes
Three Stripes Sportswear 1.73 0.21 1.11 No
Swoosh Sportswear 1.84 0.24 1.19 Yes
Das Auto Car Production 1.68 0.41 0.74 No
Oilstat Oil & Gas 1.29 0.42 1.42 Yes
Galactica Space Exploration 3.50 0.50 0.25 Yes
Zero G Space Exploration 3.00 0.80 0.10 Yes
Footnotes:
1. EG’s equity cost of capital is 10% and its debt cost of capital is 5%
2. Always use EG’s debt cost of capital as an approximation for a project’s debt cost of
capital
3. Currently, long-term treasury bonds have a yield of 2%, long-term investment grade
corporate bonds have an average yield of 4%, and non-investment grade long-term
corporate bonds have an average yield of 7%.
4. The market risk premium is 5%.
a. Calculate the project’s annual free cash-flows (from t=0 to t=3). [7 marks]
b. Use the information provided by the CEO, including her specific instructions, to
calculate EG’s WACC. Use this WACC to calculate the project’s NPV using the
WACC method. [7 marks]
c. Is the method used in (b) correct? Motivate your answer. [4 marks]
d. Would you calculate the WACC differently? If so, calculate it, and re-calculate the
project’s NPV using the WACC method. Compare your answers to questions (b) and
(d). Are the NPVs different? If so, why are they different, and does the difference
affect the investment decision? Comment briefly. [7 marks]

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