Make an APV Layout: 201306Q1

Bahari Project

Bahari is a small country with agriculture as its main economic activity. A recent geological survey concluded that there may be a rich deposit of copper available to be mined in the north-east of the country. This area is currently occupied by subsistence farmers, who would have to be relocated to other parts of the country. When the results of the survey were announced, some farmers protested that the proposed new farmland where they would be moved to was less fertile and that their communities were being broken up. However, the protesters were intimidated and violently put down by the government, and the state-controlled media stopped reporting about them. Soon afterwards, their protests were ignored and forgotten.

In a meeting between the Bahari government and Mlima Co’s BoD, the Bahari government offered Mlima Co exclusiverights to mine the copper. It is expected that there are enough deposits to last at least 15 years. Initial estimates suggest that the project will generate free cash flows of $4 million in the first year, rising by 100% per year in each of the next two years, and then by 15% in each of the two years after that. The free cash flows are then expected to stabilise at the year-five level for the remaining 10 years.

The cost of the project, payable at the start, is expected to be $150 million, comprising machinery, working capital and the mining rights fee payable to the Bahari government. None of these costs is expected to be recoverable at the end of the project’s 15-year life.

The Bahari government has offered Mlima Co a subsidised loan over 15 years for the full $150 million at an interest rate of 3% instead of Mlima Co’s normal borrowing rate of 7%. The interest payable is allowable for taxation purposes.

It can be assumed that Mlima Co’s business risk is not expected to change as a result of undertaking the Bahari project.

Make an APV Layout: 201306Q1（a2）

Required:

(a) Prepare a report for the Board of Directors (BoD) of Mlima Co that:

(i) Explains why Mlima Co’s directors are of the opinion that Mlima Co’s cost of capital should be based on Ziwa Co’s ungeared cost of equity and, showing relevant calculations, estimate an appropriate cost of capital for Mlima Co; (7 marks)

(ii) Estimates Mlima Co’s value without undertaking the Bahari project and then with the Bahari project. The valuations should use the free cash flow methodology and the cost of capital calculated in part (i). Include relevant calculations; (14 marks)

PV of the tax shield and subsidy：

Annual tax shield benefit interest paid=3%×$150m×25%=$1.1m

Subsidy benefit=4%×$150m×(1-25%)=$4.5m

Annuity factor (7%,15 years)=9.108

PV of tax shield and subsidy benefit=5.6×9.108=$51.0m

Adjusted present value=$120.5m+$51.0m-$150.0m=$21.5m