calculate the npv and pricing models, Macroeconomics

Burwood Mining is raising capital of $500,000 for its next project from the following sources:

Sources

Amount $

Common stock

100,000

Preferred stock

50,000

Bank loan

150,000

Debenture

100,000

Retained arnings

100,000

Total

500,000

The annual return on the Treasury securities is 11%; the market index indicates that the average return on the market is 18%. The company has issued its debt instruments promising to pay interest of 15% p.a.. The company has also secured a bank loan at 14%. The Burwood company's equity beta has recently gone up to 1.4; such increase is due to the introduction of Carbon Tax. The company is subject to a tax rate of 35%. The company management has also decided to pay the holders of preferred stock 300 basis points less return than their common stock holders.

Scenario 1- The proposed new project is expected to bring an annual after tax cash flow of $100,000 forever. The project however faces a 20% probability of getting $70,000 annually, after paying tax, in perpetuity.

Scenario 2- Everything in the scenario 1 is the same except that if it is a failure the business would be worth only $300,000 at the end of the first year. You however are unsure of the probability of success and failure in this scenario.

Burwood Mining Ltd is also aware that a large competitor has expressed an interest in acquiring the project at the end of the first year for $400,000 regardless of the outcome of the expansion. The sale price would include any cash flows accrued during the first year of trading.

Question:

(i)  Calculate the NPV of the project in scenario 1

(ii). Applying one of the option pricing models that you have learnt, value the abandonment option available to Burwood Mining Ltd in the form of a possible sale of the business to the large competitor company. Use the NPV that you obtained in Scenario 1 as the current value of Mining project.

Posted Date: 2/16/2013 5:34:52 AM | Location : United States







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