calculate the npv and pricing models, Macroeconomics

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


Amount $

Common stock


Preferred stock


Bank loan




Retained arnings




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.


(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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