Page 144 - AFM Integrated Workbook STUDENT S18-J19

Chapter 7

Question 2

Craig Co is an advertising company. The directors are evaluating a new
investment project in the insurance sector. The project’s forecast free cash
flows are:

$000 T 0 T 1 T 2 T 3 T 4 T 5

FCF (3,500) 700 800 800 1,300 1,000

The company’s existing weighted average cost of capital is 8%, and the
corporate tax rate is 20%.

Craig Co currently has a gearing ratio (debt to equity by market values) of
20:80, but this will change if the new project is undertaken because the
directors are intending to raise finance (net of issue costs) as follows:

$000

Rights issue of equity 500

Bank borrowings, repayable in 5 years 3,000

3,500

Two thirds of the debt will be subsidised by the government at a rate of 40
basis points below the current risk-free interest rate. The remaining one third
will carry a fixed interest rate of 5% per year.

Issue costs of 3% of gross proceeds are payable on all debt, and issue costs
of $40,000 will be payable on the rights issue. Issue costs on debt and equity
are not tax allowable.

The average industry equity beta for the insurance industry is 1.80 and the
average gearing ratio (debt to equity by market values) is 50:50.

The debt beta can be assumed to be zero. The current risk-free rate is 3% and
the market risk premium is 7%.

Required:

Calculate the adjusted present value (APV) of the project.

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