Fin701 Spring 2020 App Practical Application For M4DHC Devel
Fin701 Spring 2020 Ap1 Practical Application For M4dhc Development
FIN701, Spring 2020 AP1 Practical Application for M4 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. For each of the following questions, you will need to show your work. That means to show the equations used for items such as required return, average expected return, profitability index, etc. When you are using the financial calculator (or Excel), identify each of your inputs. Anyone looking at your work should be able to replicate your answer based on the backup info you provide.
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: Boom, Probability: 20%, Return: 35%
- State of the Economy: Normal, Probability: 55%, Return: 12%
- State of the Economy: Recession, Probability: 25%, Return: -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 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))
2. 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 Beta: 1.2
Project B Beta: 0.9
Project C Beta: 1.4
Project D Beta: 1.0
For each project, calculate the NPV, IRR, profitability index (PI), and the payback period. Assume each project is independent of the others and use the required rate of return computed in part 2.
Expected cash flows for the four potential projects:
| 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 | $800,000 | $1,250,000 | $750,000 | $1,250,000 |
| 5 | $300,000 | $1,250,000 | $750,000 | $1,250,000 |
For each project, create a table to show the required return (from part 2), NPV, IRR, PI, and payback period. Use your calculations to determine whether each project should be accepted or rejected based on these metrics. Remember, all projects must be completed within 6 years or less to meet the firm's payback rule.
3. Discuss your results. What are the similarities and differences among the acceptance/rejection decisions produced by different capital budgeting techniques? Could discrepancies among these methods pose a problem for the firm? Which decision method appears most helpful or least helpful, and why?
4. Finally, the venture capital firm invested $15 million. Based on the projects accepted using the "gold standard" NPV method, which projects should the firm fund within the $15 million budget? Identify the accepted projects, total initial investment, and total NPV for this portfolio. Ensure your total initial outlay does not exceed $15 million.
Sample Paper For Above instruction
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