Company “AIBM” has debt with a market value of £2,500,000 and equity with a mark

Question

Company “AIBM” has debt with a market value of £2,500,000 and equity with a market value of £5,500,000. The financial management estimates that the company’s shares have a beta of 1.85. The risk premium on the market is 8%, and the current Treasury bill rate is 5%. Debt is risk-free, and company “AIBM” has a corporate tax rate of 35%. Company “AIBM” is now considering whether investing in two new independent projects X and Y. Each project has an expected life of 6 years. Project X requires an initial cash outflow of £100,000, and subsequent annual cash inflows of £50,000 (year 1), £60,000 (year 2), £50,000 (year 3), £60,000 (year 4), £100,000 (year 5), and £50,000 (year 6). Project Y requires an initial cash outflow of £100,000, and subsequent annual cash inflows of £40,000 (year 1), £100,000 (year 2), £30,000 (year 3), £50,000 (year 4), £50,000 (year 5), and £50,000 (year 6). Both projects X and Y are similar to the company’s existing operations.

Required:

A. Calculate the beta of the assets of company “AIBM”. [5 marks]

B. Calculate the cost of equity capital and the weighted average cost of capital (WACC) after tax of company “AIBM”, assuming validity of the capital asset pricing model (CAPM). [8 marks]

C. Calculate the net present value (NPV) of projects X and Y, and discuss which project(s) should be accepted according to the NPV method. [10 marks]

D. Calculate the profitability index (PI) of projects X and Y. Which project(s) should be accepted according to the PI method? [5 marks]

E. Introduce the notion of “average accounting return” (AAR) and illustrate strengths and weaknesses of the AAR method within the framework of strategic investment appraisal decisions.

Explanation / Answer

A. Asset beta is also known as Unlevered Beta.

Asset Beta = Equity Beta + [1+(1-tax rate)(debt/Equity)]

Let Equity Beta is assumed in given question i.e. 1.85

Then,

= 1.85 + [1+(1-35%)(25,00,000/55,00,000)]

=3.145

B.

C. NPV of the Projects-

So, In this case Project X is beneficial for the Company because its give higher return.

Profitability Index-

Project X-

Npv/Initial Investment

=163903/100000

=1.64

Project Y-

Npv/Initial Investment

=134968/100000

=1.35

WACC Particular Amount Weight Cost WACC Debt $25,00,000 0.3125 3.25 1.015625 Equity share $55,00,000 0.6875 10.55 7.253125 WACC 8.26875 W.N.1 KD = Interest(1-tax) 5(1-35%) KD = 3.25 W.N.2 KE= Risk Free Rate + Beta(Market return-Risk Free) Risk Free Rate + Beta(Market risk premium) 8%+1.85*(8%-5%) KE= 7.25

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