Question
Given the following information: Sales $500,000 per year in perpetuity Cash costs 72% of sales Initial Investment $500,000 Tax Rate 34% Project debt-equity proportion 25/75
- Given the following information:
Sales | $500,000 per year in perpetuity |
Cash costs | 72% of sales |
Initial Investment | $500,000 |
Tax Rate | 34% |
Project debt-equity proportion | 25/75 |
Interest on debt | 10% per year |
Company’s geared equity beta | 1.8 |
Market return | 5% |
Risk-free rate | 3% |
Calculate the value of the project using the NPV-FTE method:
Assuming that the project has no impact on the company’s debt-equity ratio
Assuming that the company rebalances its debt-equity ratio
Gem Bhd. is considering an investment in new production line – plastic recycling division. To start this new production line, they need to purchase new machinery that costs RM7 million. It is expected to generate annual before-tax cash inflows of RM1.5 million into perpetuity. The cost of production is expected to be 60% of the cash inflows. The depreciation of the machinery is RM200,000 per annum; while the repair and maintenance costs for the machinery are RM100,000 per annum. No inflation is considered in this case.
To invest in this machinery, Gem needs to get 60% of non-traded irredeemable debenture with a coupon rate of 8%. The remaining of fund will come from retained earnings in the company.
The plastic recycling industry has a geared equity beta of 1.4 and a debt-to-asset ratio of 1:5 by market values. The company has ungeared equity beta of 1.2. The yield on short-term government debt is 4% per year and the market risk premium is 5% per year. GEM pays corporate tax at an annual rate of 30%.
Analyse and advise GEM whether they should invest in this project by calculating the net present value using flow-to-equity method. State clearly the assumptions you make. Assume that GEM rebalances their debt-equity ratio.
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