QUESTION 3 25 MARKS The Green Energy company is evaluating an investment of building a new production plant. The cost of the new plant is $500k with an estimated useful life of 10 years. At the end of the project's life, all plant equipment will be removed and sold for $0.2m a year later. The company decides to raise the equity required by issuing common stock onto the share market. The company is listed on the stock exchange with a B value equal to the volatility of the stock market. The company expects to maintain the existing capital structure at a risk free rate of 5% and a risk premium of 8%. Issuing the stock generates a cost of funding the equity of 6%. It is estimated that the annual cash flow generated will be $100k for the first five years increasing to $150K in subsequent years for the remainder of the project. The corporate tax rate in Australia is 30%. The capital structure is such that the company has a 25% debt ratio. The cost of the debt capital is 9% whereas the cost of funding the debt raised is 4%. a) Draw the cash flow diagram that represents the above investment scenario. [2 MARKS] [8 MARKS] [6 MARKS] [4 MARKS] b) Calculate the WACC. c) Carry out an NPV of the project. d) Taking into account the true cost of funding the project determine if you would proceed with the investment. e) (i) Explain what the B value of a stock represents. (ii) What is the B value of the stock market? (iii) Explain the significance of a negative B value. (iv) By what percentage would a stock with a beta of 1.5 rise by if the market rose by 10% ? (v) What does the capital asset pricing model (CAPM) enable us to calculate? [5 MARKS] QUESTION 3 25 MARKS The Green Energy company is evaluating an investment of building a new production plant. The cost of the new plant is $500k with an estimated useful life of 10 years. At the end of the project's life, all plant equipment will be removed and sold for $0.2m a year later. The company decides to raise the equity required by issuing common stock onto the share market. The company is listed on the stock exchange with a B value equal to the volatility of the stock market. The company expects to maintain the existing capital structure at a risk free rate of 5% and a risk premium of 8%. Issuing the stock generates a cost of funding the equity of 6%. It is estimated that the annual cash flow generated will be $100k for the first five years increasing to $150K in subsequent years for the remainder of the project. The corporate tax rate in Australia is 30%. The capital structure is such that the company has a 25% debt ratio. The cost of the debt capital is 9% whereas the cost of funding the debt raised is 4%. a) Draw the cash flow diagram that represents the above investment scenario. [2 MARKS] [8 MARKS] [6 MARKS] [4 MARKS] b) Calculate the WACC. c) Carry out an NPV of the project. d) Taking into account the true cost of funding the project determine if you would proceed with the investment. e) (i) Explain what the B value of a stock represents. (ii) What is the B value of the stock market? (iii) Explain the significance of a negative B value. (iv) By what percentage would a stock with a beta of 1.5 rise by if the market rose by 10% ? (v) What does the capital asset pricing model (CAPM) enable us to calculate? [5 MARKS]
