Africa Industries is an industrial conglomerate is currently evaluating a project to produce a new electronic lock
mechanism recently developed by the company. The project will require an immediate outlay of NOK 100 000 on production machinery. The machinery would have a zero scrap value at all times and would not be allowable expense against tax (as working capital but with zero value at project end). The project is expected to have a 3-year life and produce a net annual cash flow of NOK 61 000 in each year. This amount would be subject to corporation tax.
Although the project only has a debt capacity of 30% of cost, the company has unused debt capacity elsewhere and so proposes to finance the project with a NOK 40 000 3-year loan, with an annual interest charge of 10%, together with a NOK 30 000 issue of equity and NOK 30 000 of retained earnings. The new equity issue will incur administration costs amounting to 2% of the money raised and the debt capital will incur a fee of 1%. Both sets of issue costs are allowable against tax.
The electronic sector has an equity beta of 1.26 and an average gearing ratio of 1:3 (debt: equity). The industry’s debt can be assumed to have a beta of 0.10. the after-tax return on bonds is 7% and the after-tax return on the Oslo Stock Exchange market index is 15.5% . Corporate tax is charged at a rate of 28% at each year-end.
a) Evaluate the project of the management of Africa Industries.
b) How would you evaluate change if the manufacturer of the production machinery offered you a 3-year NOK 100 000 interest free loan (with an issue cost of 1%).