## (Solved) Peter is considering investing in Paxology, a new business venture owned by Maria.

Peter is considering investing in Paxology, a new business venture owned by Maria. Her business plan shows that if the project is successful, Paxology is expected to generate the following cash flows for its investors:

Year Cash Flow (Â£)

1 0

2 230,000

3 450,000

4 1,800,000

The cash flow in the fourth year includes cash flows that would be receivable from selling the business to a third party at that time. You initially concluded that the cash flow estimates provided by Maria were reasonable. Peter is looking for seed capital of Â£200,000 to undertake the venture. Paxology is expected to be viable, if it is successful after the initial investment. Required:

a) Using 40 percent and 100 percent hurdle rates, estimate the present value of Paxology and the fraction of equity you would need to cover your investment.

b) Peter now decides to undertake due diligence as any investment in Paxology will be substantial. After due diligence work, Peter concludes that the probability that Paxology will be successful through Year 2 is about 70 percent, through Year 3 is about 50 percent and through Year 4 is about 30 percent. If Paxology fails, it will not return any cash to its investors. Determine the discount rates of the expected cash flows that would yield the same ownership fraction as the 40 percent hurdle rate in part (a).

c) Suppose Peter can establish that for each of the annual cash flows of Paxology described in part (a), the correlation between project cash flows and the market is 25 percent. He also determined that the market risk premium is 6 percent, the risk free interest rate is 3.5 percent, the standard deviation of market returns is 15 percent for one year, 24 percent for two years, 32 percent for three years, and 39 percent for four years. Using the certainty equivalent form of the Capital Asset Pricing Model, find the present value of the project.

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This question was answered on: Sep 05, 2019

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