solve13 - FNCE 3010 (Durham). HW 13 - WACC 1. If you can...

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FNCE 3010 (Durham). HW 13 — WACC 1. If you can borrow all the money you need for a project at 6 percent, does it follow that 6 percent is your cost of capital for the project? Solution: No. The cost of capital depends on the risk of the project, not the source of the money. 2. 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 look- ing 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 project would have a net present value of $1 million at an 18 percent discount rate and a -$1.1 million NPV at a 22 percent discount rate. Dow has a beta of 1.25, whereas Superior has a beta of .75. The expected risk premium on the market is 8 percent, and risk-free bonds are yielding 12 percent. Should either company proceed? Should both? Explain. Solution: Superior is in the natural gas production business and is probably close to a pure play. Using the CAPM, we see that Superior’s cost of capital is .12 + .75(.08) = .1800 or 18.00%. Using this discount rate, the proposed project has a positive NPV and should be pursued. The appropriate discount rate does not depend on which company is investing;
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This note was uploaded on 03/31/2008 for the course FNCE 3010 taught by Professor Donchez,ro during the Fall '07 term at Colorado.

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solve13 - FNCE 3010 (Durham). HW 13 - WACC 1. If you can...

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