What level of annual earnings must the new project generate

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Reference no: EM132771305

Apollo Limited is contemplating a Rs.5 crore expansion project. The Company has a well stated policy that it will reject any proposal that will adversely affect the market value of the firm's equity.

The new project is likely to give a rate of return of 14% before taxes. An investment company is willing to finance the project through a private placement of 5 crore in the form of 10% p.a. interest bearing bonds. Apollo's shares have historically been selling at P/E of 10. Current earnings are Rs.2.70 and the company is in the 50% tax bracket.

The present Capital structure of the company is:

Long term debt (8%) 1,00,00,000

Common Stock (Rs.2 par value, 1 crore shares outstanding) 2,00,00,000

Retained earnings 17,00,00,000

Total capital 20,00,00,000

Problem a) The COO of the company wants to go ahead with the private placement. Her argument is that since the before tax marginal cost of the project is 10% (interest on new loan) and the likely before tax returns from the project are higher than 10% the company should go ahead. Discuss.

Problem b) Assuming after the project is accepted Apollo's P/E declines to 9, what level of annual earnings (before interest and taxes) must the new project generate in order to meet the company's objective of no change in the value of the stock price.

Reference no: EM132771305

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