Chong and Rama founded LitLup Sdn Bhd (LitLup) in 2017. LitLup is a specialist manufacturer of LED aviation obstruction beacons (OB) used for obstacle marking of telecommunication towers, high buildings, transmission lines for aviation safety purposes. LitLup patented OB lights are hermetically sealed and fully integrated. Inherently built in with lighting surge protection and IP67 (Ingress Protection) certified, LitLup lights are durable, robust and reliable. It is compact and lightweight, providing easier handling and installation at site. A difficult operating year, 2018, was followed by a profitable company in 2019. The founders are interested in estimating their cost of financial capital since they are expecting to secure additional external financing to support planned growth. Short-term bank loans are available at an 8% interest rate. Chong and Rama believe that the cost of obtaining long-term debt and equity capital will be somewhat higher. The real interest rate is estimated to be 2% and a long-run inflation premium is estimated at 3%. The interest rate on long-term government bonds is 7%. A default-risk premium on long-term debt is estimated at 6%; plus, LitLup is expecting to have to pay a liquidity premium of 3% due to the illiquidity associated with its long- term debt. The market risk premium on large-firm common stocks over the rate on long-term government bonds is estimated to be 6% and a market beta of 1.00. Chong and Rama expect that equity investors in their venture will require an additional investment risk premium estimated at two times the market risk premium on large-firm common stocks. The following is the income statement and balance sheet for LitLup Sdn Bhd. for the financial years ended 2018 and 2019. LITLUP SDN BHD 31/12/2018 (RM) 31/12/2019 (RM) Net sales 900,000 1,500,000 Cost of goods sold (540,000) (900,000) Gross profit 360,000 600,000 Marketing (90,000) (150,000) General and administrative (250,000) (250,000) Depreciation (40,000) (40,000) EBIT (20,000) 160,000 Interest (45,000) (60,000) Earnings before taxes (65,000) 100,000 Income taxes (25,000) Net income (loss) (65,000) 75,000 31/1/2/2018 31/12/2019 (RM) (RM) Cash 50,000 20,000 Accounts receivable 200,000 280,000 Inventories 400,000 500,000 Total current assets 650,000 800,000 Gross fixed assets 450,000 540,000 Accumulated depreciation (100,000) (140,000) Net fixed assets 350,000 400,000 Total assets 1,000,000 1,200,000 Accounts payable 130,000 160,000 Accruals 50,000 70,000 Bank loan 90,000 100,000 Total current liabilities 270,000 330,000 Long-term debt 300,000 400,000 Common stock (.05 par) 150,000 150,000 Additional paid-in-capital 200,000 200,000 Retained earnings Total liabilities and equity 80,000 1,000,000 120,000 1,200,000 Questions 1. (a) Calculate the following ratios for both 2018 and 2019 for LitLup Sdn. Bhd. (i) Net profit margin (ii) Assets turnover ratio (iii) The equity multiplier (iv) The return on equity (b) Evaluate the financial performance of LitLup Sdn Bhd between the two years. 2. Estimate the following cost for LitLup Sdn Bhd. a) Short-term bank loans b) Long-term debt c) Common equity capital (1 Mark) (1 Mark) (1 Mark) (1 Mark) (2 Marks) (1 Mark) (1 Mark) (1 Mark) 3. (a) Estimate the weighted average cost of capital (WACC) for the LitLup Sdn Bhd using the book values of interest-bearing debt and stockholders' equity capital at the end of 2019. (2 Marks) (b) Chong and Rama estimate that the market value of the common equity in the venture is RM900,000 at the end of 2019. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2019. Estimate the market value-based weighted average cost of capital for LitLup Sdn Bhd. (2 Marks) (c) Would you recommend to Chong and Rama that they use the book value-based WACC estimate or the market value-based WACC estimate for planning purposes? Why? (2 Marks)