Reference no: EM132466499

DHC Development Co. has several new projects that look attractive, but some are riskier than the firm's past projects. DHC has received a $15 million inflow of cash from a venture capital firm, in exchange for 20% of the firm's closely held stock. The VC firm has asked DHC managers to "run the numbers" to examine both the market outlook and the expected returns on each of the projects they are considering.                                                                                              

1. Based on DHC's earnings history over the past 15 years, which have covered various states of the economy, the venture capital execs want DHC to estimate their overall returns. Given the following estimates of economy over the next several years, determine DHC's expected rate of return.

Note, this type of development firm has much higher than normal returns under normal and boom conditions.          

State of the Economy              Probability of State of the Economy    Rate of Return if State Occurs

Boom                                                   20%                                                                 35%

Normal                                                            55%                                                                 12%

Recession                                             25%                                                                 -15%                                        

Expected return for "average" company project = 

2. Historically, DHC projects have had an average beta of 1.15    Assuming the return on the overall market is 9.25% and the risk free rate is 1.5%, what is the required return for an "average" DHC project using based on its average project beta? Round the average required return to 2 decimal places (x.xx%).  Hint: Remember that the market risk premium = return on the market - risk free rate,         R = Rf + (β*(Rm - Rf))

Expected return for "average" company project = 

3. The potential projects that DHC is considering have the following expected cash flows.  Each project has its own unique risk and as such, the beta on each project is given. Using the data from part 2 for the risk free rate and market returns, what is the required percentage return for each of the projects? Show the required returns to 2 decimals, that is xx.xx%

Project A                     Project B                     Project C                     Project D

Beta                 1.3                               0.9                               1.1                               1.6                   

4-7. For each project, calculate the NPV, IRR, profitability index (PI) and the payback period. For each capital budgeting decision tool, indicate if the project should be accepted or rejected, assuming that each project is independent of the others. Important Note: The venture capital folks have a hard and fast rule on payback period, all projects must be completed within 6 years or less.

Expected cash flows for the four potential projects that DHC is considering as shown below:

Year                 Project A         Project B         Project C         Project D         

0                      -$4,000,000     -$8,000,000     -$6,000,000     -$3,000,000

1                      $1,000,000      $1,250,000      $1,500,000      $300,000

2                      $1,000,000      $1,250,000      $1,500,000      $500,000

3                      $1,000,000      $1,250,000      $2,500,000      $500,000         

4                      $1,000,000      $1,250,000      $2,500,000      $750,000

5                      $800,00                       $1,250,000                              $750,000

6                      $0                    $1,250,000                              $750,000

7                      $800,000         $1,250,000                              $750,000

8                      $300,000         $1,250,000                              $750,000

9                                              $1,250,000                              $750,000

10                                            $1,250,000                              $750,000

I have provided a suggested template for your final answers. Below the grid (and/or next page) is where you should put all required backup calculations. If one is working this in Excel, feel free to submit the Excel sheet, where the equations in the cells will provide the required backup. Be sure to clearly indicate the required rate of return (from part 3) for each project.   

                        Year                             Project A         Project B         Project C         Project D

                        Req Return

                        (use 2 decimals

                                    xx.xx%)

            4a.      NVP (to nearest $1)

            4b. NVP accept / reject

            5a. IRR (xx.xx%)

            5b. IRR accept / reject

            6a. PI (shows 2 decimals)

            6b. PI accept / reject

            7a. Payback Period (x.x years) 

            7b. Payback accept / reject

Show supporting equations and / or calculation inputs. 

8. Discuss results. What I'm looking for is a short discussion of how some capital budgeting techniques provide the same accept/reject decision, while others do not. Can this be a problem for the firm? Which of the decisions methods seems the most helpful (and why) and which least helpful (and why)?

9. Finally, recall that the venture capital firm only provided $15 million in funding. That $15 million is the funding that will cover the initial investments required on projects. Assuming all projects that are acceptable using the "gold standard", NPV, which of those projects should be accepted, while staying within the $15 mm budget. Identify the projects that should be accepted, the total outflow at time 0 (must be within your budget) and the total NPV.