Integrating Cost of Capital and Capitial Budgeting
Response to the following problem:
Zylon Co. is a U.S. ?rm that provides technology software for the government of Singapore. It will be paid S$7 million at the end of each of the next 5 years. The entire amount of the payment repre- sents earnings since Zylon created the technology software years ago. Zylon is subject to a 30 percent corporate income tax rate in the United States. Its other cash in?ows (such as revenue) are expected to be offset by its other cash out?ows (due to operat- ing expenses) each year, so its pro?ts on the Singapore contract represent its expected annual net cash ?ows. Its ?nancing costs are not considered within its estimate of cash ?ows. The Singapore dollar (S$) is presently worth $.60, and Zylon uses that spot exchange rate as a forecast of future exchange rates.
The risk-free interest rate in the United States is 6 percent while the risk-free interest rate in Singapore is 14 percent. Zylon's capital structure is 60 percent debt and 40 percent equity. Zylon is charged an interest rate of 12 percent on its debt.
Zylon's cost of equity is based on the CAPM. It ex- pects that the U.S. annual market return will be 12 percent per year. Its beta is 1.5.
Quiso Co., a U.S. ?rm, wants to acquire Zylon and offers Zylon a price of $10 million.
Zylon's owner must decide whether to sell the business at this price and hires you to make a recommendation. Estimate the NPV to Zylon as a result of selling the business, and make a recommendation about whether Zylon's owner should sell the business at the price offered.