Discussion:Application of MM Propositions in capital budgeting analysis

AB plc manufactures products for children. The entity's turnover and earnings last year were $56m and $3.5m, respectively. Its shares are not listed but they occasionally change hands in private transactions. AB plc's weighted average cost of capital (WACC) is 13% net of tax. The directors believe that an appropriate gearing ratio (debt to debt + equity) for a company such as AB plc is 30%, which is the industry average. Currently, AB plc's gearing ratio is slightly higher than this at 35%. Its debt comprises two secured long-term bank loans and a permanent overdraft, secured by a floating charge on the company's current assets. The current cost of debt to an entity such as AB plc is 10% before tax.

The entity is considering expansion outside Canada, in particular in an Eastern European (EE) country where its products have become popular. The EE government has offered AB plc a financing deal to establish a manufacturing operation. The financing would take the form of an EE marks 30m 6-year loan at a subsidized rate of only 2.5% each year interest. The current exchange rate is EE marks 20 to the Canadian dollar. Interest would be payable at the end of each year and the principal repaid at the end of 6 years. The exchange rate of EE marks to the Canadian dollar would be fixed at the current rate for the whole 6-year period of the loan. The marginal corporate tax rate in both countries is 25%.

Q1.Calculate the entity's present cost of equity and the present value of the EE government subsidy implicit in the loan. Comment briefly on the method used and any assumptions you have made in your calculations.