Question
Company AIBM has debt with a market value of 2,500,000 and equity with a market value of 5,500,000. The financial management estimates that the companys
Company AIBM has debt with a market value of 2,500,000 and equity with a market value of 5,500,000. The financial management estimates that the companys shares have a beta of 1.85. The risk premium on the market is 8%, and the current Treasury bill rate is 5%. Debt is risk-free, and company AIBM has a corporate tax rate of 35%. Company AIBM is now considering whether investing in two new independent projects X and Y. Each project has an expected life of 6 years. Project X requires an initial cash outflow of 100,000, and subsequent annual cash inflows of 50,000 (year 1), 60,000 (year 2), 50,000 (year 3), 60,000 (year 4), 100,000 (year 5), and 50,000 (year 6). Project Y requires an initial cash outflow of 100,000, and subsequent annual cash inflows of 40,000 (year 1), 100,000 (year 2), 30,000 (year 3), 50,000 (year 4), 50,000 (year 5), and 50,000 (year 6). Both projects X and Y are similar to the companys existing operations.
Required:
A. Calculate the beta of the assets of company AIBM. [5 marks] (the answer is 1.27)
B. Calculate the cost of equity capital and the weighted average cost of capital (WACC) after tax of company AIBM, assuming validity of the capital asset pricing model (CAPM). [8 marks] (answers: cost of equity capital is 0.193 and WACC after tax is unknown)
C. Calculate the net present value (NPV) of projects X and Y, and discuss which project(s) should be accepted according to the NPV method. [10 marks]
D. Calculate the profitability index (PI) of projects X and Y. Which project(s) should be accepted according to the PI method? [5 marks]
E. Introduce the notion of average accounting return (AAR) and illustrate strengths and weaknesses of the AAR method within the framework of strategic investment appraisal decisions.
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