Diddly Squat Inc. 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 $150,000. This is expected to produce net post-tax annual operating cash flows of $18,500 into perpetuity. The projects assets will support debt finance of 40% of its initial cost. The loan will be irredeemable and carry an annual interest rate of 12%. 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. Diddlys current geared (equity) beta is 1.8, and 20% of its long-term capital is represented by debt thats generally seen as risk-free. The risk- free rate is 8% a year and the expected return on an average market portfolio is 15%. Corporation tax is set at 30%.

1. Calculate the adjusted present value of the proposed project. State any assumptions you make clearly. (14 marks)

2. Should Diddly Squat proceed with this investment? What other factors should you consider besides the net present value? (6 marks)