NPV
Base Case
1. All Equity Financing
It
is assumed that project is being finance entirely equity. It means that there
is no gearing involved.
2. Asset beta is relevant
Because
it is assumed that, there is only equity financing. Therefore only asset beta
is relevant, therefore if asset beta is not given, then asset beta is
calculated for new business (using information of new business).
3. Cost of Equity (CAPM)
Cost
of equity is calculated on the bases of asset beta, and not on the base of equity
beta, and that cost of equity is used to discount the cash flows.
4. Discount Cash flows
Cost
of equity is used to discount the cash flows (inflows & outflows) and to
find NPV, such Base case NPV.
Example
Food
business and have debt to capital ration 40:60 and equity beta of 1.3. The
company interested in diversification and plan to enter in shoe making which
has debt equity financing ratio 50:50 and equity beta 1.5, tax rate is 30, risk
free 8% , market return is 12%. Initial investment 500,000 and 3 years cash
profit are 300,000. Calculate NPV Base
- 1. Asset Beta Calculation
Asset Beta =
Value of Equity x Beta
Ve+Vd (1-t)
= 50 x 1.5
50+35
=.8823
(Asset Beta)
2.
Cost of Equity
Calculation
Cost
of equity = 8% + .88 (4%)
=11.52%
(Cost of Equity)
3.
Base NPV Calculation
Cash
outflows
(500,000)
Cash
Inflows 300,000 x 2.42
726,534
NPV Base Cash 226,534
