Shalima Berhad is a private company involved in aluminium mining. Due to high metal prices worldwide, the company has been growing successfully. However, because the company has significant debt borrowings with strict restrictive covenants and high interest levels, it has had to reject a number of profitable projects. The company currently has two bonds in issue, as follows:

• A 16% secured bond with a nominal value of RM80 mil, which is redeemable at par in five years. An early redemption option is available on this bond, giving Shalima the option to redeem the bond at par immediately if it wants to; and
• A 13% unsecured bond with a nominal value of RM40 mil, which is redeemable at par in ten years.

Shalimas Board of Directors (BoD) has been exploring the idea of redeeming both bonds to provide it with more flexibility when making future investment decisions. To do so, the BoD has decided to consider a public listing of the company on a major stock exchange. It is intended that a total of 100 million shares will be issued in the newly-listed company. From the total shares, 20% will be sold to the public, 10% will be offered to the holders of the unsecured bond in exchange for redeeming the bond through an equity-for-debt swap, and the remaining 70% of the equity will remain in the hands of the current owners. The secured bond would be paid out of the funds raised from the listing.

The details of the possible listing and the distribution of equity were published in national newspapers recently. As a result, potential investors suggested that due to the small proportion of shares offered to the public and for other reasons, the shares should be offered at a substantial discount of as much as 20% below the expected share price on the day of the listing.

It is expected that after the listing, deployment of new strategies and greater financial flexibility will boost Shalimas future sales revenue and, for the next four years, the annual growth rate will be 120% of the previous two years average growth rate. After the four years, the annual growth rate of the free cash flows to the company will be 3.5%, for the foreseeable future. Operating profit margins are expected to be maintained in the future. Although it can be assumed that the current tax-allowable depreciation is equivalent to the amount of investment needed to maintain the current level of operations, the company will require an additional investment in assets of 30 cents per RM1 increase in sales revenue for the next four years.

Information from Shalima Berhad's past three years Profit & Loss Statements
	2018 RM million	2019 RM million	2020 RM million
Sales revenue	344.7	366.3	389.1
Operating profit	51.7	54.9	58.4
Net interest costs	18	17.7	17.5
Profit before taxes	33.7	37.2	40.9
Taxes	8.4	9.3	10.2
Profit after taxes	25.3	27.9	30.7

Once listed, Shalima will be able to borrow future debt at an interest rate of 7%, which is only 3% higher than the risk-free rate of return. It has no plans to raise any new debt after listing, but any future debt will carry considerably fewer restrictive covenants. However, these plans do not take into consideration the Masai project (see below).

Masai Project

Masai is a small country with agriculture as its main economic activity. A recent geological survey concluded that there may be a rich deposit of copper available to be mined in the north-east of the country. In a meeting between the Masai government and Shalimas BoD, the Masai government offered Shalima exclusive rights to mine the copper. It is expected that there are enough deposits to last at least 15 years.

Initial estimates suggest that the project will generate free cash flows of RM4 million in the first year, rising by 100% per year in each of the next two years, and then by 15% in each of the two years after that. The free cash flows are then expected to stabilise at the year-five level for the remaining 10 years. The cost of the project, payable at the start, is expected to be RM150 million, comprising machinery, working capital and the mining rights fee payable to the Masai government. None of these costs is expected to be recoverable at the end of the projects 15-year life.

The Masai government has offered Shalima a subsidised loan over 15 years for the full RM150 million at an interest rate of 3% instead of Shalimas normal borrowing rate of 7%. The interest payable is allowable for taxation purposes. It can be assumed that Shalimas business risk is not expected to change as a result of undertaking the Masai project.

Other Information

Shalimas closest competitor is Almas Berhad, a listed company which mines metals worldwide. Shalimas directors are of the opinion that after listing Shalimas cost of capital should be based on Almas ungeared cost of equity. Almas cost of capital is estimated at 9.4%, and its pre-tax cost of debt is estimated at 4.76%. These costs are based on a capital structure comprising of 200 million shares, trading at RM7 each, and RM1,700 million 5% irredeemable bonds, trading at RM105 per RM100. Both Almas and Shalima pay tax at an annual rate of 25% on their taxable profits.

It can be assumed that all cash flows will be in RM instead of the Masai currency and therefore Shalima does not have to take account of any foreign exchange exposure from this venture. Questions

1. Estimate Almas levered cost of equity.

(8 marks)

Estimate Shalimas cost of unlevered equity.