Syfy is considering investing in a project with the following details. The initial cost of investing in equipment is estimated to be Rs1,200,000. However, the project is deemed to produce operating cash flows (after tax) of Rs323,000 each year till infinity excluding the interest tax shield.
The project is expected to be about 34.26% more revenue volatile than the rest of the company's products, and will have fixed costs equal to 40% of operating profit compared with a corresponding figure of 5% for the rest of the company. The project will be financed in such a way that the capital structure of the project will be the same as that of Syfy. The project will be partly financed by debt and investment bankers will require a return (project cost of debt) of 10%. per annum.
Syfy's shares are traded on the stock exchange and have a beta coefficient of 1.0885. The company also has debt outstanding, comprising 35% of Syfy's total value and having a beta value of 0.20.
The risk free return is 5% per annum and the average market risk premium is 10%. The tax rate is 15% and is levied on operating net cash flows.
Required:
The directors of Nose plc have the following queries:
(i) What is the current WACC of Syfy plc and can this be used as a discount rate to evaluate the project?
(ii) Provide relevant calculations and supporting explanatory notes on how an appropriate discount rate for the project could be determined?
(iii) Is the project acceptable? Provide supporting calculations.
(iv) Explain the usefulness of the adjusted present value technique as a method for evaluating projects.