Real Options: Arturo Berhad Should Expand The Business

2218 words - 9 pages

(a) (i)
WACC= E/V × Re+ D/V × Rd × (1-TC)

*Re = Cost of Equity = 16.65%
Rd = Cost of Debt = 7.00%
E/V=Percentage of financing that is equity= 100/130
D/V=Percentage of financing that is debt= 30/130
TC = Corporate tax rate = 0.25 = 25%

WACC= 100/130 × 16.65%+ D30/130 × 7.00% × (1-0.25)
Cost of Capital = 14.02% - 2.5%
= 11.52%

*Re = 3% + 2.1 (6.5%)
= 16.65%

(a) (ii)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Unit Sales (A) 2,000 3,500 4,200 5,000 5,100
Revenues (B) 17,000,000 29,750,000 35,700,000 42,500,000 43,350,000
Production cost (3,400,000) (5,950,000) (7,140,000) (8,500,000) (8,670,000)
Direct Marketing Expenses (1,700,000) (2,975,000) (3,570,000) (4,250,000) (4,335,000)
Depreciation (10,000,000) (10,000,000) (10,000,000) (10,000,000) (10,000,000)
Earning before Tax 1,900,000 10,825,000 14,990,000 19,750,000 20,345,000
Tax @ 25% (475,000) (2,706,250) (3,747,500) (4,937,500) (5,086,250)
Profit after tax 1,425,000 8,118,750 11,242,500 14,812,500 15,258,750
Add: Depreciation 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000
Cash flow-operation 11,425,000 18,118,750 21,242,500 24,812,500 25,258,750

Working Capital @ 12% 2,040,000 3,570,000 4,284,000 5,100,000 5,202,000 0
Increase in Working Capital (2,040,000) (1,530,000) (714,000) (816,000) (102,000) 5,202,000
Initial investment of plant (50,000,000) 8,000,000
Tax on gain @ 25% (2,000,000)
Net Cash Flow (52,040,000) 9,895,000 17,404,750 20,426,500 24,710,500 36,460,750
Discount factor @12% 1.0000 0.8967 0.8041 0.721 0.6465 0.5797
Present Value (52,040,000) 8,872,846.50 13,995,159.48 14,727,506.50 15,975,338.25 21,136,296.78
Net present value 22,667,148

Since the Net present value is positive, Arturo Berhad should proceed with the project.

b(i)

Real options are alternatives that can be undertaken to modify the projects. Most managers often call real option as intangible advantages. According to Investopedia (2009), real option is an alternative that can be considered when there is excess capacity and there are business investment opportunities pertaining to tangible assets. It assumes that management is logical, competent and acts in the best interests for both the company and shareholders by maximizing wealth and minimizing losses (Mun, 2009). It also assess on the flexibility of the managers to consider other alternatives available to successfully run the project. On top of that, this practices usually involves careful framing of an investment decision problem in order to improve the design of the project and at the same time enhance shareholder value (Triantis, 2003). Last but not least, it can also be the most useful tools in making decisions as it includes qualitative factors in making decisions.

There are many real options that the company can look into and implement the options in their company. One of the alternatives that Arturo Berhad is advised to...

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