Page 336 - AFM Integrated Workbook STUDENT S18-J19

Chapter 15

Solution

Base case NPV

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

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

DF @ 1 0.909 0.826 0.751 0.683 0.621
10%(W1)

PV (3,500) 636 661 601 888 621

So base case NPV is ($93,000) i.e. negative.

(W1) The discount rate needs to be an ungeared cost of equity representing
the risk associated with the new project’s business sector (i.e. insurance).

The asset beta of insurance companies can be found from the industry
information as follows: (given that the debt beta is zero)

V E 50
ß = ß V + V [1 – t] =1.80 50 + 50[1 – 0.20] 1.00
a
e
D
E
Using CAPM, ungeared cost of equity:
k e = R F + ß (E(R M) – R F) = 3% + (1.00 x 7%) = 10%

Financing side effects – issue costs

Equity issue costs = $40,000 (given)

Debt issue costs = $3 million x (3/97) = $92,784

(therefore the total debt finance (100%) is $3,092,784)

Financing side effects – present value of subsidy benefit

Benefit = $3,092,784 x (2/3) x (0.05 – 0.026) x (1-0.20) x 4.329 = $171,375

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