Question

Hudson Furniture specializes in office furniture for self-employed individuals who work at home. Hudson’s furniture emphasizes style rather than utility and has been quite successful. The firm is now considering entering the more competitive industrial furniture market where volumes are higher but pricing is more competitive. A $10 million investment is required to enter the new market. Management anticipates positive cash f lows of $1.7 million annually for eight years if Hudson enters the field. An average stock currently earns 8%, and the return on Treasury bills is 4%. Hudson’s beta is .5, while that of an important competitor who operates solely in the industrial market is 1.5. Should Hudson consider entering the industrial furniture market?

Answer 1

The answer is Hudson should not enter the industrial furniture market because the NPV calculated at the required rate of return is negative ( as shown in the explanation).

Step-by-step explanation:

As Hudson plans to enter into the new market, the beta of its important competitor should be used instead of the firm current beta which is only appropriate under the current business model.

Thus, the firm's require rate of return = Risk free rate ( Rate on treasury bill) + Beta of important competitor ( Market return rate - Risk free rate) = 4% + 1.5 x ( 8% - 4%) = 10%

Thus, 10% will be the required rate of return for evaluating the investment.

We have net present value of the investment is:

-10,000,000 + (1,700,000/0.1) x ( 1 - 1.1 ^-8) = $-930,625

=> As net present value of the investment is negative, Hudson should not invest.