Reference no: EM132417186

Problem: You are Founder McDougal, and have invented a prototype of a product you have named the Cleanserizer. The Cleanserizer automatically cleans pools, eliminating the need for pool owners to hire companies to clean their pool, or pay for chemicals (such as chlorine) to remove algae build-up.

You have performed thorough market research, and discovered you will be the first to market with such a product. Within a year, you are confident your product can be on store shelves and selling to anxious customers the world over. 

In advance of going to market, your new company (Cleanser, Inc.) will need to invest $980,000 immediately to build out your marketing and distribution team and begin to produce inventory. With a sales price of $199, production costs of $45 per unit, annual salaries for your staff of $290,000, and various other administrative costs (rent, pens, etc.) amounting to $135,000 annually, you have determined that your project should (in expectation) produce free cash flows of $120,010 at the end of your first year, $280,000 at the end of year two, and $350,000 at the end of year three. Due to the fact the market will be saturated at that point, the project will only produce $325,000 for years four through ten, after which the product will be obsolete (generate no future free cash flows).

Unfortunately, you do not currently have $980,000 to invest, and have approached Capital Markets, Inc., an investment firm, to see if they would be willing to give you the required investment in exchange for an equity claim in your company. After careful consideration of your project's systematic risk, you have determined your project has a beta of 3.5. 

Worried that Capital Markets, Inc. might not be interested in your project, you look into other investments they have made. In the last month, they made an investment in TreasuryBonds, a company with a beta of 0.0 who claim "we make all of our money risk-free", and an investment in TypicalAsset, who have a beta of 1.0 and state, on their website, "we aren't risk-free, we're just average risky". Capital Markets Inc., demanded a return of 3% from TreasuryBonds and 7% from TypicalAsset. 

There are no taxes in this world.

Question 1: "Wow," you think to yourself, "Capital Markets, Inc. demanded a 7% return from TypicalAsset, and they only have a beta of 1.0! How much am I going to have to promise as a return?" 

What is your company's cost of capital?

Question 2: During your meeting with Capital Markets, Inc., they want to know if you have determined the net present value of your project. What is the net present value of your company?

Question 3: Capital Markets, Inc. is enthusiastic about your project and is willing to invest! In less than three sentences, why do you think Capital Markets, Inc. is willing to invest?

Question 4: Capital Markets, Inc. has written, and your company has now cashed, the check for $980,000. You have also made the initial $980,000 investment.   What is the net present value of your project?

Question 5: A friend of your talks to you, "Your NPV is too low, it is not enough to cover the initial investment. Even if you have an investor who is interested in putting up money, they are going to own the entire project and you will get nothing for your efforts." In less than four sentences, explain whether your friend is right or wrong, and why.