Question 4 (20 marks)

APL Ltd., with the nature of the business is to produce automobile parts that include radiators, cooling devices, lighting devices, heat treatment devices, semi-finished products assembly line, as well as wheel assembly line, an others. BMW, Mercedes Benz, Volvo among others are its major customers. Nicholas Nevins, Chief Executive Officer (CEO) and general manager of the company, oversees the production, purchasing, management information systems, financial, research and development, marketing and the quality control department.

APL Ltd, a private firm in the widget industry, is considering a new investment project. It currently has a target debt-equity ratio of 0.4, which is slightly higher than the industry target debt-equity ratio of 0.35. The industry average beta is 1.2. The market return is 12 percent, and the risk-free rate is 5 percent. Assume that all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 40 percent.

The project requires an initial outlay of $675,000 and is expected to have $95,000 cash inflow at the end of the first year. Annual cash flows from this project will grow at a constant rate of 5 percent until the end of the fifth year and remain constant forever thereafter. Answer following questions and state any assumptions you make.

1. What is the levered return on equity in the widget industry? (3 marks)
2. What is the unlevered return on equity in the widget industry? (3 marks)
3. What is the weighted average cost of capital of APL? (6 marks)
4. Shall APL invest in the project? (8 marks)