Question
Kilimani Ltd is considering diversifying its operations away from its main area of business (food manufacturing) into the plastics business. The company wishes to evaluate
Kilimani Ltd is considering diversifying its operations away from its main area of business (food manufacturing) into the plastics business. The company wishes to evaluate an investment project which involves acquisition of a molding machine that costs sh.450,000,000. The project is 4 expected to produce annual pre-tax operating cash flows of sh.220,000,000 for each of the three years of its useful life. Its salvage value is zero. The assets of the project will support debt finance of 40% of its initial cost (including issue cost). The loan is to be repaid in three equal annual instalments. The balance of the finance will be provided by placing of new equity. Issue costs will be 5% of the equity and 2% for the loan. Issue costs are tax allowable. The plastics industry has an average equity beta of 1.368 and an average debt to equity ratio of 1:5 at market values. Kilimani Ltd.s current equity beta is 1.8 and 20% of its long term capital is represented by debt which is generally regarded to be risk free. The risk free rate is 8% per annum and the expected return on an average market portfolio is 16%. The machine will attract a 60% capital allowance in the first year and the balance will be written off evenly over the remainder of the assets life and will be allowable against tax. The Firm is certain that it will earn sufficient profits against which to offset these allowances. Corporate tax rate is at 30%. Required: Using Adjusted Present Value (PV) approach, advice whether or not the project is worthwhile. (Total:10 Marks)
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