The Chris-Kraft Co. is financed entirely with equity, and the firm has a beta of 1.25. The current risk-free rate is 7 percent, and the expected market return is 15 percent. Chris-Kraft is considering an investment project with a risk that matches the firm's average risk, requires a net investment of $70,000, and has net cash flows of $18,000 per year for 8 years. Should Chris-Kraft invest in the project?
A) Yes, since NPV = $5,726
B) Yes, since NPV = $75,726
C) No, since NPV = -$10,934
D) No, since NPV = -$5,726

Question

Quizplus · Accepted Answer

To calculate the NPV, we need to use the following formula:
NPV = PV of cash inflows - Initial investment
PV of cash inflows = CF1 / (1+r)^1 + CF2 / (1+r)^2 + ... + CF8 / (1+r)^8
where CF = cash flow and r = discount rate
For Chris-Kraft, since the project has the same risk as the firm's average risk, we can use the firm's beta as a measure of the project's risk. The required return for the project is:
r = r_f + β * (r_m - r_f) = 0.07 + 1.25 * (0.15 - 0.07) = 0.16
Now we can calculate the PV of cash inflows and the NPV:
PV of cash inflows = $18,000 / (1+0.16)^1 + $18,000 / (1+0.16)^2 + ... + $18,000 / (1+0.16)^8 = $103,514.27
NPV = $103,514.27 - $70,000 = $33,514.27
Since the NPV is positive, Chris-Kraft should invest in the project. The correct answer is A).