Advanta Bhd. is a medium-sized manufacturing company that plans to increase capacity by purchasing new machinery at an initial basic price of RM1.5 million. The shipping costs will be RM27,000 and an additional cost of RM73,000 to modify it for special use by the firm. It will depreciate to zero over the five-year useful life using the straight-line method, but it is expected to be sold for RM65,000.
The investment is expected to increase annual sales by 6,000 units. Financial data on the additional units to be sold is as follows:
After the first year, the sales price and variable costs will increase at the inflation rate of 3% per annum.
Working capital is 15% of sales (the year prior to the anticipated sales) and will be fully recovered at the end of the project life.
The beta factor of this investment is 1.0. The company targeted capital structure is 60% equity and 40% debt. The cost of debt after tax is 9%. The market rate of return is 14% and the risk-free is 4%. An average-risk project has a coefficient of variation of NPV between 0.8 and 1.2.
Question 2
Malton Bhd. has made the following forecast for the upcoming year based on the company’s current capitalization:
The company has RM20 million worth of debt outstanding, and all of its debt yields 10 percent. The company’s tax rate is 26 percent. The company’s price-earnings (P/E) ratio has traditionally been 12´,
The company’s investment bankers have suggested that the company recapitalize. Their suggestion is to issue enough new bonds at a yield of 10 percent to repurchase 1 million shares of common stock. Assume that the stock can be repurchased at RM40.
Assume that the repurchase will have no effect on the company’s operating income; however, the repurchase will increase the company’s dollar interest expense. Also, assume that because of the increased financial risk, the company’s price-earnings (P/E) ratio will be 11.5 after the repurchase.
