A US firm called X is looking to diversify its operations away from its main business (manufacturing food) by setting up a plastic division. Its first potential project entails buying a molding machine for $100,000. This is expected to produce net post-tax annual operating cash flows of $15,000 into perpetuity. The project’s assets will support debt finance of 40% of its initial cost. The loan will be irredeemable and carry an annual interest rate of 10%. The balance of finance will come from a placing of new equity (assume that no issue costs will be associated with this).

The plastic industry has an average geared (equity) beta of 1.368 and a debt-to-equity ratio of 1:5 by market values. X’s current geared (equity) beta is 1.8, and 20% of its long-term capital is represented by debt that’s generally seen as risk-free. The risk-free is 10% a year and the expected return on an average market portfolio is 15%. Corporation tax is set at 30%.

Evaluate the project using:

(1) Current WACC as a discount rate;

(2) An adjusted WACC as a discount rate

2a. Assume that the project has no impact on X’s debt-equity ratio

2b. Assume that X rebalances its debt-equity ratio

Answer rating: 100% (QA)

To evaluate the project using the current WACC as a discount rate we need to calculate the current W... View the full answer