The primary motive of any company is to maximize the wealth of its shareholders (Megginson & Smart, 2009). Accordingly, the companies should aim to invest in those projects which have a positive Net Present Value (NPV) as projects with positive NPV result in value addition to the shareholders wealth (Shapiro, 2008) while projects with negative NPV destroy value. Though projects with zero NPV have no effect on the value of the company, it is often argued that instead of wasting resources in zero NPV projects, it is better to return them to the shareholders so that they can pursue better investment opportunities.
There are several discounted cash flow techniques that can be used for valuation purposes, but as the project has been expected to be financed by retained earnings only, the free cash flows to equity (FCFE) owners have been computed and the Net Present Value of these cash flows have been computed by discounting the cash flows (inflows as well as outflows) at the cost of retained earnings. The cost of retained earnings have been computed as per the Capital Asset Pricing Model which states that the cost of equity is computed as the sum of the risk free rate and the beta of the stock multiplied by the market risk premium so as to compensate the equity shareholders for investments in stocks whose beta differs from that of the overall market. The cost of equity (or the discount rate) of the new project has been computed as shown under: