ABC is contemplating a Rs.5 crore expansion project. The Company has a well

stated policy that it will reject any proposal that will adversely affect the market value of

the firms equity. The new project is likely to give a rate of return of 14% before taxes. An

investment company is willing to finance the project through a private placement of 5 crore

in the form of 10% p.a. interest bearing bonds. ABCs shares have historically been

selling at P/E of 10. Current earnings are Rs.2.70 and the company is in the 50% tax

bracket.

The present Capital structure of the company is:

Long term debt (8%) 1,00,00,000

Common Stock (Rs.2 par value, 1 crore shares outstanding) 2,00,00,000

Retained earnings 17,00,00,000

Total capital 20,00,00,000

a) The company wants to go ahead with the private placement.

Her argument is that since the before tax marginal cost of the project is

10% (interest on new loan) and the likely before tax returns from the

project are higher than 10% the company should go ahead. Discuss.

b) Assuming after the project is accepted ABCs P/E declines to 9, what level

of annual earnings (before interest and taxes) must the new project generate

in order to meet the companys objective of no change in the value of the

stock price.