Corporate Finance
12th Edition
ISBN: 9781259918940
Author: Ross, Stephen A.
Publisher: Mcgraw-hill Education,
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Chapter 13, Problem 7CQ
Company Risk versus Project Risk Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major natural gas producer, are thinking of investing in natural gas wells near Houston. Both are all-equity financed companies. Dow and Superior are looking at identical projects. They’ve analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be the same for both firms. No debt would be used to finance the projects. Both companies estimate that their projects would have a
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The Salad Oil Storage Company (SOS) has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet.
a. explain why SOS stockholders could lose by investing in a positive-NPV project financed by an equity issue.
b. explain why SOS stockholders could gain by investing in a highly risky, negative-NPV project.
A firm is considering Projects S and L, whose cash flows are shown below. These projects are
mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR
criterion, while the CFO favors the NPV method. You were hired to advise the firm on the
best procedure, given a WACC of 15%. If the wrong decision criterion is used, how much
potential value would the firm lose?
Project
Year 0
Year 1
Year 2
Year 3
Year 4
S
-$995 million
$385 million
$400 million
$525 million
$650 million
L
-$2.05 billion
$705 million
$835 million
$950 million
$1.025 billion
$6.04 million
O $359.08 million
$46.04 million
$451.15 million
O $405.11 million
A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? (compare NPVs for projects)WACC: 6.75%Year 0 1 2 3 4 CFS -$1,025 $380 $380 $380 $380CFL -$2,150 $765 $765 $765 $765
Chapter 13 Solutions
Corporate Finance
Ch. 13 - Project Risk If you can borrow all the money you...Ch. 13 - WACC and Taxes Why do we use an aftertax figure...Ch. 13 - SML Cost or Equity Estimation If you use the stock...Ch. 13 - SML Cost or Equity Estimation What are the...Ch. 13 - Prob. 5CQCh. 13 - Cost of Capital Suppose Tom OBedlam, president of...Ch. 13 - Company Risk versus Project Risk Both Dow Chemical...Ch. 13 - Prob. 8CQCh. 13 - Leverage Consider a levered firms projects that...Ch. 13 - Beta What factors determine the beta of a stock?...
Ch. 13 - Prob. 1QAPCh. 13 - Prob. 2QAPCh. 13 - Prob. 3QAPCh. 13 - Prob. 4QAPCh. 13 - Prob. 5QAPCh. 13 - Prob. 6QAPCh. 13 - Prob. 7QAPCh. 13 - Prob. 8QAPCh. 13 - Prob. 9QAPCh. 13 - Prob. 10QAPCh. 13 - Prob. 11QAPCh. 13 - Prob. 12QAPCh. 13 - Prob. 13QAPCh. 13 - Prob. 14QAPCh. 13 - Prob. 15QAPCh. 13 - Prob. 16QAPCh. 13 - Prob. 17QAPCh. 13 - Prob. 18QAPCh. 13 - Prob. 19QAPCh. 13 - Prob. 20QAPCh. 13 - Prob. 21QAPCh. 13 - Prob. 22QAPCh. 13 - Prob. 23QAPCh. 13 - Prob. 24QAPCh. 13 - Prob. 1MCCh. 13 - Prob. 2MCCh. 13 - Go to www.reuters.com and find the list of...Ch. 13 - You now need to calculate the cost of debt for...Ch. 13 - You now have all the necessary information to...Ch. 13 - You used Tesla as a representative company to...
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- A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? WACC: 6.00% Year 0 1 2 3 4 CFS -$1,025 $380 $380 $380 $380 CFL -$2,150 $765 $765 $765 $765 $198.61 $219.51 $209.07 O $188.67 $230.55arrow_forwardRisk-adjusted rates of return using CAPM Centennial Catering, Inc., is considering two mutually exclusive investments. The company wishes to use a CAPM-type risk-adjusted discount rate (RADR) in its analysis. Centennial's managers believe that the appropriate market rate of return is 12.2%, and they observe that the current risk-free rate of return is 7.4%. Cash flows associated with the two projects are shown in the following table. (Click on the icon here in order to copy the contents of the data table below into a spreadsheet) Initial investment (CFO) Year (f) 1 234 Project X $67,000 Project Y $84,000 Cash inflows (CF) $30,000 30,000 30,000 30,000 $26,000 32,000 42,000 48,000 a. Use a risk-adjusted discount rate approach to calculate the net present value of each project, given that project X has an RADR factor of 1.19 and project Y has an RADR factor of 1.39. The RADR factors are similar to project betas. (Hint: Use the following equation to calculate the required project return…arrow_forwardRisk and NPV; Sensitivity Analysis J. Morgan of SparkPlug Inc. has been approached to takeover a production facility from B.R. Machine Company. The acquisition will cost $1,500,000, andthe after-tax net cash inflow are expected to be $275,000 per year for 12 years.SparkPlug currently uses 12% for its after-tax cost of capital. Tom Morgan, production manager,is very much in favor of the investment. He argues that the total after-tax net cash inflow is more thanthe cost of the investment, even if the demand for the product is somewhat uncertain. “The project willpay for itself even if the demand is only half the projected level.” Cindy Morgan (corporate controller)believes that the cost of capital should be 15% because of the declining demand for SparkPlug products.Required1. What is the estimated NPV of the project if the after-tax cost of capital (discount rate) is 12%? Use thebuilt-in NPV function in Excel; round your answer to the nearest whole dollar. 2. What is the estimated NPV of…arrow_forward
- A tire manufacturing firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. What is the cost of capital at which the decision to take project L (or S) based on NPV will contradict the decision based on IRR method? Hint: Calculate the crossover rate and explain how the crossover rate would influence your decision to take project L or project S based on NPV vs. IRR? Show your excel work and thoroughly explain your answer. See cash flows below: Year 0 1 2 3 4 Project L: CFL -$2,050 $770 $780 $790 $795 Project S: CFS -$4,300 $1,300 $1,510 $1,520 $1,530arrow_forwardthe Kosovski Company is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and are not repeatable. If decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost. WACC: CFS CFL a. $35.69 b. $29.26 c. $31.31 d. $26.33 e. $34.82 6.25% 0 -$1,050 -$1,050 1 $675 $360 2 $650 $360 3 $360 4 $360arrow_forwardNast Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher MIRR rather than the one with the higher NPV, how much value will be forgone? Note that under some conditions choosing projects on the basis of the MIRR will cause $0.00 value to be lost. WACC: 9.25% CFS CFL 1 2 3 4 -$1,200 $405 $405 $405 $405 -$2,400 $780 $780 $780 $780 0 a. $0.00 b. $210.59 c. $120.02 d. $8.26 e. $7.56arrow_forward
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