1) How much importance should be given to the energy cost situation? Michael Burton’s proposal to expand into new energy efficient products is justified by increasing interest in the public and private sectors to reduce energy costs. At the highest level of government, the Obama administration has tied the US economy’s energy policy with its future success and competitiveness with other global powers. In a speech on June 2009, President Obama specifically mentions the Energy Department’s plans to implement “…aggressive efficiency standards for common household appliances – like refrigerators and ovens – which will spark innovation, save consumers money, and reduce energy demand.”1 Sarah Max from Money magazine (2010) also mentions that…show more content… The expected value of project is negative $1.67M, and therefore deemed risky from our perspective.
Table 5: Expected Value Analysis
Weak Average Strong NPV -$11,995,012.01 -$2,177,050.14 $6,047,687.74 x x x Probability 20% = 50% = 30% = EXPECTED VALUE -$2,399,002.40 -$1,088,525.07 $1,814,306.32 -$1,673,221.15
3) What is the project’s cost of equity? What is the appropriate discount factor to use for evaluating the refrigerator project? Without factoring in Tesca’s debt, the project’s cost of equity can be calculated using the Capital Asset Pricing Model (CAPM), which essentially tells us how much Tesca’s investors can expect in return, given the company’s level of risk and rates of return. The CAPM formula is as follows:
Rs = Rrf + (Rm) β
Rs = Rate or Cost of Common Stock Rrf = Risk Free Rate Rm = Market Risk Premium β = Stock’s Relative Risk
Brighman and Ehrhardt (2011)5 indicate that many companies use the 10-year Treasury note rate for their Risk Free Rate (Rrf); therefore Tesca’s Rrf = 3% or 0.03. The Market Risk Premium is based on the S&P 500 forecast of 6%. Finally, the Beta (β) or the amount of risk associated with Tesca’s stock relative to the market, is established at 1.30. When these values are factored into the CAPM formula, the cost of equity for this project is equal to 0.108 or 10.8%. According to Investopedia, the cost of equity can be interpreted to mean: that Tesca’s refrigerator project
