The Expando Company has three new projects that are being evaluated. The company’s WACC is estimated at 14.6 per cent after effective company tax. The expected after-tax returns and CAPM betas of the three projects are as follows:
The risk-free interest rate is 9 per cent and the expected return on the market portfolio is 16.5 per cent.
(a) Which of the projects should be accepted?
(b) Would any of the accept/reject decisions change if the projects were evaluated using the company cost of capital?
Question 2. Calculating cost of capital
The management of Heavy Clay Ltd wants to know the cost of capital associated with expanding its business. You have been told that funds will be raised for this purpose according to a target capital structure reflected in the market value of its securities. Your task is to calculate the cost of capital for the company. The following information may assist you in your task:
(a) The 13 per cent debentures have just been issued and interest rates have remained stable since the issue. This rate was 1 per cent per annum above the interest rate on government securities.
(b) The last observed market price of the preference shares was $1, whereas it was $3 for the ordinary shares.
(c) The beta of equity of Heavy Clay was recently estimated at 0.5, while the consensus view is that the expected rate of return for the market is 18 per cent.
(d) An extract of the most recent statement of financial position shows:
Liabilities and shareholders’ funds ($’000)
7% preference shares ($2 face value) 1,000
Paid-up capital ($1 face value) 3,000
(e) The company income tax rate is 30 cents in the dollar.
Question 3. Company versus project cost of capital
Dorset Ltd is all-equity financed and has a cost of capital of 16 per cent per annum. An observer suggests that Dorset could easily borrow up to 40 per cent of the value of its assets at an interest rate of 10 per cent per annum and achieve a rating for its debt of A+ or better.
He argues that raising new capital by borrowing would lower the company’s cost of capital, and increase the net present value of some projects that were recently rejected.
Use a numerical example to illustrate the observer’s argument. Is his argument correct? Give reasons for your answer.
Question 4. Net present value analysis
Bethela Ltd purchased a machine 7 years ago for $85 000. When it was purchased the machine had an expected useful life of 17 years and an estimated value of zero at the end of its life. The machine, which is being depreciated on a straight-line basis, currently has a written-down value of $50000 and a current market value of $20000. The manager reports that he can buy a new machine for $120 000 (including installation), which, over its 10-year life, will result in an expansion of sales from $90 000 to $120 000 per annum.
In addition, it is estimated that the new machine will reduce annual operating costs from $70000 to $60000. If the tax rate is 30 cents in the dollar, and the effective after-tax required rate of return is 10 per cent per annum, should Bethela buy the new machine?
Question 4. Project evaluation
A company is considering purchasing a new machine at a cost of $900 000 to replace a machine purchased 6 years ago for $1 million. The disposal value of the old machine is $250 000 and the accumulated depreciation, which has been allowed for tax purposes, is $600 000. Both machines will have similar outputs and will produce work of identical quality. The estimated yearly costs of operating each machine are as follows:
Both machines have an estimated remaining life of 4 years, at which time both machines will have an estimated disposal value of $90 000. Assume that:
(a) the after-company-tax cost of capital is 10 per cent per annum
(b) the operating costs of the old machine and the new machine are incurred at the end of each year
(c) the company income tax rate is 30 cents in the dollar.
Should the company purchase the new machine?