Hi guys,
Need some help in explain the answer for this question as I don't understand what they means...
Here is the question:
A project costs £100,000 and has an operating cash flow of £10,000 in the first two years and £40,000 in the following three years. The project stops at the end of year 5. The expected return on the market index is 12% and the risk free rate is 5%.
(b) Suppose the operating cash flow consists of both revenues and costs, and suppose the expected revenue each year is 120% of the net expected operating cash flow given above, while the expected costs each year are 20% of the net expected operating cash flow. You should assume that the costs are uncorrelated with the movements of the market index. The revenues have a beta of 0.75. Work out the NPV of the project.
And the answer give is:
The cost of discount rate for the costs is 5 per cent. The discount rate for revenues is 5% + 0.75(12%−5%) = 10.25%. The costs are 2, 2, 8, 8, and 8; and the revenues are 12, 12, 48, 48, and 48.
The present value of the costs is 2/1.05 + 2/1.052 +... = 23.5; the
present value of the revenues is 12/1.1025 + 12/1.10252 +... = 118.5
The present value of future cash flow is 118.5 – 23.5 = 95. The net present value is therefore −100 + 95 = −5, and the project should be rejected.
From my understanding
I believe the cost of discount rate for the cost is 5% is due to uncorrelated with the movement of the market index therefore the discount rate should be the risk free rate but I don't understand on the part for the discount rate of the revenue and how did they get the cost of 2... and revenues of 12...