Question

A firm has 500,000 shares outstanding at a price of $100/share so that its market value is (500KS100)= $50M. The firm's investment projects are financed by debt only. Currently the firm is considering an investment project that will cost $1,000,000 and generate cash flows of $500,000, $400,000, $400,000, and

$130,000 in years I through 4.
(a)If the current required rate of return is 20%, find the present value of the cash flows. Note: This is actually a net present value.
(i)Based on your answer in part (1), should the firm invest in this project?
(b) The Federal Reserve decides to stimulate the economy by purchasing a large quantity
of Treasury Securities. The outcome is that the required rate for the firm is now 15%.
Find the present value of the cash flows (or net present value) as in part a(1).
(ii) Based on your answer in b(i), should the firm invest in this project?
(c)Based on your answer to b(ii), how much value is added to each share?
(ii) If the price of each share was $100 before, how much will it be after news of this
investment is made public? Note: Apply Semi-Strong Form EMH.
d. If the firm invests in the project, has the project been indirectly made liquid? Note: This is
for the rate at 15% case.

Answer 1

The present value of the cash flows is $997,685 and the firm should not invest in this project.

Step-by-step explanation:

The present value of the cash flows can be calculated by discounting each cash flow back to the present at the required rate of return. With a required rate of return of 20%, the present value of the cash flows can be calculated as follows:

1. Year 1: $500,000 / (1 + 0.20) = $416,667
2. Year 2: $400,000 / (1 + 0.20)2 = $277,778
3. Year 3: $400,000 / (1 + 0.20)3 = $231,481
4. Year 4: $130,000 / (1 + 0.20)4 = $71,759

The present value of the cash flows is the sum of these discounted cash flows:

$416,667 + $277,778 + $231,481 + $71,759 = $997,685

Based on this answer, the firm should not invest in this project as the present value of the cash flows is less than the cost of the investment, which is $1,000,000.