In general, students are expected to meet the following objectives: 1) To ascertain cost of capital for

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Question:

In general, students are expected to meet the following objectives: 1) To ascertain cost of capital for a new project by using cost of capital of existing firms operating in the same business. (2) Perform various valuation techniques in capital budgeting decision.
Instruction: Analyse questions 1 until 6 and write a report of not more than 2,500 words (excluding tables & references). Your written report must also attach with an excel spreadsheet and supporting documents if necessary. Take note that this report is meant Mr Ramli who is not well verse in finance. Hence, you need to explain the intuition behind your calculations. For example, tell Mr Ramli why different discount rates (RWACC, RE and RO) are used to discount the cash flows in different NPV methods. And why it makes sense to use peers’ cost of equity to estimate Mr Ramli’s new venture, etc.

The Case
Mr Ramli was a founder of business that specializes in the plastic moulding industries. His business has been established in the market since mid-1990s as a privately owned company. The company has been grown steadily over the years with all the profits being reinvested in the business.
Recently, he intended to expand his company by launching a new plastic moulding line. Thus, he needed to calculate the net present value (NPV) of the projected cash flows to determine the attractiveness of the new expansion. His key concern was determining a reasonable discount rate to apply to cash flows in order to calculate the project's net present value (NPV). Mr Ramli approached a consultant friend to look into the comparable businesses in the same industry's cost of capital. In this case, the basic idea is that businesses in the same sector often have similar clients, activities, and properties, thus they face similar business risks and should have similar capital costs.
The first step to value the project, Mr Ramli prepared projected earnings for the coming five years. He also prepares projected balance sheet and estimated cash flow. Although the growth rate over the 5-years forecast period was high, he felt that the growth rate will be stabilised at 5 percent per year after the initial high growth of 5 percent at the initial high growth phase. His main concern was to find a suitable discount rate to be applied to cash flows to ascertain the NPV of project.

Expansion Plan
The demand for plastic products was growing in the country and thus there are a lot of potential demand from other countries. However, the company could not realize its hidden potential as investment in capital expenses over the last few years. Mr Ramli felt the new investment needed to be installed on a priority basis and capital expenditures had to be continued to sustain the growth the firm.
The new manufacturing line for plastic products would involve the usage of eco-friendly plastic ingredients and production technologies such that the final plastic products are recyclable. This is in line with Mr Ramli’s wish to become an Environmental, Social and Governance (ESG) plastic moulding company. Mr Ramli aims to make his company to be the first plastic moulding company to be included in Bloomberg’s ESG rating. Research has shown that ESG rated companies received a higher valuation and have greater access to financing, thus, lower cost of capital.

Financial assessment
Mr Ramli wanted to maintain separate accounts for the new projects so that performance of the new expansion could be monitored independently. Through the debt component for the parent company was negligible, the new projects were proposed to be financed with the debt to asset of 30.6% with debt value of $8 million. Accordingly, projected balance sheet for the next 5 years were prepared and can be found in Exhibit 2.
To estimate profitability of the new project, Mr Ramli could easily estimate free cash flow to the firm for the next 5 years from the projected financial statement. Although the operations were expected to grow at a high rate during the next 5 years, Mr Ramli debt that the growth may not be sustainable in the long run and considered a perpetual growth rate of 5 percent per year in cash for beyond the initial five years. The main problem was to find a suitable discounting rate for the company. As the company was not listed in any stock exchange, project beta and cash flow cannot be determined.
According to the consultant’s suggestion, Mr Ramli should evaluate the riskiness of similar plastic moulding company listed in the market and estimate the cost of capital of the company using publicly available information. As it was difficult to identify a single company whose risk profile would exactly match the plastic moulding project, he decided to review the cost of capital of the major plastic moulding companies operating in Malaysia. Since there was limited plastic moulding companies managed privately, the comparison was limited to companies listed in the Bursa Malaysia stock exchange. Mr Ramli decided to use the business risk of these companies as his reference point.
Refer to Exhibit 2 for the details of competing firms. These companies were operating in the same business domain and should have broadly similar business risk and thus similar cost of capital. To arrive the cost of equity of these companies using CAPM (Capital asset Pricing Model). Mr Ramli requires measures of equity beta, risk free rate and expected market rate of return. The Beta (β) of a stock measures the correlated volatility of an equity stock in relation to the volatility of benchmarked asset. A stock market index is generally used as a benchmark. The formula for estimating equity beta of a firm is:
βequity=(Cov(r equity, r market index))/(Var (r market index))
r equity= rate of return on equity
r market index= rate of return of market portfolio
Cov(r equity, r market index)= Covariance from two rates of return
Beta can also be estimated using regressing the return series of the stock against stock market index. The equity betas of the companies were calculated using the daily stock prices of these companies and the value of KLCI stock marke index. Historically, the 10 year government bond yielded on an average 3% return. In the country, interest rate decision are taken by the central bank. Considering these factors, Mr Ramli use risk free rate 3% per year. This rate also closely matched the discount rate of long term maturity trasury bills. Mr. Ramli carried out a survey where market risk premium of several countries were compiled. As a result, Mr Ramli decides to apply a market risk premium of 8%. He was confident these inputs were adequate to ascertain cost of capital of the firm. To keep the analysis simple, he assumed a uniform tax rate of these companies at 30%. Further, debts of the companies including his companies were considered risk free and an identical cost of debt of 3% and 5% respectively were taken for the valuation plan.
Exhibit 1: Selected Projected Cash Flow Items (million dollar)
Year 1 2 3 4 5
Cash inflows 4,400 4,900 5,400 5,900 6,400
Cash costs 2,400 2,700 3,000 3,300 3,600

Exhibit 2: Plastic Moulding companies
Company Year Ending Face value Book Value Market Cap
(Million Dollar) Net Income
(Million Dollar) Equity
(Million Dollar) Debt
(Million Dollar) Equity Beta
Eng Huat Plastic Dec 2019 10 222.1 8704 142.2 3,774.2 1740.8 0.5472
Jaki Plastic Mar 2020 2 43.5 58,237.8 1,678.7 5,200.4 17471.1 0.2638
Avery Plastic Dec 2019 10 272 121,160.1 3,552 11,441.82 24232 0.2
Bolder Plastic Mar 2020 10 46 74,938.8 1073.4 2,995.5 11240.7 0.9856
Fitness Plastic
Mar 2020 1 8.9 6,116.3 909.9 910.5 1223.2 0.6357
George Plastic Mar 2020 1 26.6 8996.9 2,347.4 23,611.8 2241.5 0.5393
National Plastic
Mar 2020 10 336.3 4669.2 351.6 3,157.9 933.8 0.669
Eastern plastic Mar 2020 10 47.8 15,336.9 676.5 1,868.6 766.8 0.5372

QUESTIONS

Calculate the levered and unlevered cash flows for the proposed moulding project for the next five years.
Year 1 Year 2 Year 3 Year 4 Year 5
Cash inflows
Cash costs
Operating income
Corporate tax
Unlevered cash flow (UCF)
Terminal value at yr 5
UCF + TV

Cash inflows
Cash costs
Operating income
Interest Payment
Income after interest
Corporate tax
Levered cash flow (LCF)
Terminal value at yr 5
LCF +TV

(6 marks)

Estimate the average cost of unlevered equity for plastic moulding companies in Exhibit 3 (Hint: Use CAPM & MM II RS formula).
(8 marks)

Estimate the cost of levered equity (RS) for Ramli’s proposed plastic moulding project (Hint: MMII RE formula, use R0=from (2) above). (3 marks)

Estimate the WACC for Ramli’s proposed plastic moulding project.
(3 marks)

Calculate net present value of the project assuming that initial investment is equal to $11 million using WACC, APV and FTE methods. What would be your recommendation?
(10 marks)

Repeat the NPV calculations using perpetuity method (use first year UCF or LCF as the cash flow variable). Explain why perpetuity cash flows yields lower NPV values than the supernormal growth cash flows in (5). (10 marks)