21st Century Cat variance of cash flows

21st Century Cat is a film producing company which is contemplating the production of a new film. They estimate that:The production of the film will require an investment of £300,000 in year 0.The distribution will generate a stream of cash flows equal to £200,000 in year 1, and£100,000 in each of years 2 and 3.In year 3, the producer will sell the rights to a tv broadcaster for £90,000.Distribution costs will be £75,000 in year 1, and £50,000 in each of years 2 and 3.Due to regulation aimed at promoting cinema, all income generated by the project istax-free.

a. The company’s financial experts say that the appropriate discount factor for the project is 10%. Calculate the NPV using this discount factor and determine whether the project should be funded.

b. Assume now that the company has a debt/equity ratio equal to one. The company’s bonds yield a 6% return, the company’s beta is equal to 0.5, the market risk premium is 5%, while the risk-free rate is 3%. Calculate the NPV of the project with the new data.

c. The experts say that the discount factor you used in b. underestimates the risk of the project. They claim that there is high uncertainty on whether the new film will be a hit or not. The variance of cash flows is accordingly very high. The relatively low beta you employ fails to capture this. How would you reply to this comment? Give your answer in no more than 100 words.