YTL wishes to evaluate an investment in new production machinery. The machinery will enable the company...

YTL wishes to evaluate an investment in new production machinery. The machinery will enable the company to satisfy increasing demand for existing products; yet, the investment is not expected to lead to any change in the existing level of business risk of the company.

The machinery will cost RM5 million and is not expected to have any scrap value. This will produce net annual after-tax cash flows of RM0.8 million into perpetuity.

YTL has, in issue, 5 million shares with a market value of RM4 per share. The ungeared equity beta of the company is 1.1. The yield on short-term government debt is 4.5% per year and the market risk premium is 5% per year.

YTL has bonds with a total book value of RM2 million. These bonds pay annual interest before tax of 7%. The par value and market value of each bond is RM100. YTL pays corporate tax at an annual rate of 25%.

Provide a reasonable estimate of weighted average cost of capital that YTL shoud use. Analyse and advise YTL whether they should go ahead with this new investment by using net present value. State clearly the assumptions you make

Expert Solution

Cost of equity is calculated by CAPM model = Risk free return+ Beta(Return of market -Return of risk Free return)

WACC = ( Equity Value * Cost of Equity + Debt value * cost of debt ) / ( Equity + debt)

Calculted in spread sheet , shown below.

Cost of Equity			Amount of Equity
	Riskfree rate	4.50%		Shares	5000000
	Beta	1.10		Price	4
	Market return	5%		Value	20000000
	Cost of Equity	5.05%

Cost of Debt			Amount of Debt
	Rate	7.00%		Book value	2000000
	Taxrate	25%		Adjustment	1
	Cost of Debt	5.25%		Value	2000000

			Total Capital		22000000

WACC		5.07%

The cash inflow after tax from this new project is RM 0.8 million in each year till infinity.

NPV = 0.8/ (1.0507)¹ + 0.8/ (1.0507)² ….. Till infinity

==( 0.8/ 1.0507) / 1-(1/1.0507) =RM15.77 million

YTL should go ahead with this new investment as NPV is Rm 15.77 Million.

jeff jeffy answered 2 years ago

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