Reference no: EM132760555

Question - Stark Bhd is considering diversifying its operations by setting up a manufacturing division to produce medical masks. Its first potential project entails buying 2 machines for a total of RM500,000. This will produce annual revenue of RM2 million, for 15 years. The cost of production is expected to be 35% of the revenue and the depreciation is RM55,000 per year, using the straight-line method. No inflation is considered in this case. After 10 years, this project will be scrapped to zero value.

Sixty per cent (60%) of the initial cost of the project will be financed by debt. The loan will be irredeemable and carry an annual interest rate of 7%. The balance of finance will come from a placement of new equity. It is assumed that there are no issue costs associated to this.

The manufacturing industry (for medical masks) has an average geared equity beta of 1.7 and a debt-to-equity ratio of 1:4 by market values. Stark's current geared equity beta is 1.5 and 25% of its long-term capital is represented by debt that's generally seen as risk-free. The risk-free rate is 3.5% a year and the expected return on an average market portfolio is 5%. Corporation tax is set at 27% per annum. Calvin does not rebalance its debt-equity ratio.

Required -

a) Calculate the net present value of this investment using the weighted average cost of capital method. State any assumptions you make clearly.

b) Should Stark proceed with this investment? What other factors should you consider besides the net present value? Explain your answer.