Mr Hadi  was a founder of business that specializes in the healthy and wellness living  industries. His business has been established in the market since mid 2000  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 smart air purifier  machine 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 Hadi 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 Hadi prepared projected earnings for the coming five years.  He also prepares projected balance sheet and estimated cash flow.  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 Hadi 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 the equipment involve the usage of eco-friendly  with the integration of artificial intelligence  tecnology. This is in line with Mr Hadi's wish to become an outstanding  Environmental, Social and Governance (ESG) smart air purifier company. Mr Hadi aims to make his company to be the first smart air purifier company to be included in the FTSE4GoodBursa Malaysia 's ESG rating.  He was shown by past research that ESG rated companies received a higher valuation and have greater access to financing, thus, lower cost of capital.

 

Financial assessment

Mr Hadi 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%[1] 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 Hadi 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 Hadi doubt that the growth may not be sustainable in the long run and considered a perpetual growth rate of 4.5 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 Hadi should evaluate the riskiness of similar smart air purifier 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 smart air purifier project, he decided to review the cost of capital of the major smart air purifier companies operating in Malaysia. Since there was limited smart air purifier companies managed privately, the comparison was limited to companies listed in the Bursa Malaysia stock exchange. Mr Hadi 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 Hadi 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=

r _equity= rate of return on equity

r _{market index}= rate of return of market portfolio

= 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 market 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 Hadi use risk free rate 3% per year. This rate also closely matched the discount rate of long term maturity trasury bills. Mr. Hadi carried out a survey where market risk premium of several countries were compiled. As a result, Mr Hadi decides to apply a market risk premium of 15%. 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. 

 

 

Question 1: Calculate the levered and unlevered cash flows for the proposed moulding project for the next five years. Provide formula. 

 

	Year 1	Year 2	Year 3	Year 4	Year 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
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

Transcribed Image Text:

Cov (r equity, r market index) Var (r market index) Cov (r equity, r market index) Var (r market index)