MAK Manufacturing is currently an all-equity firm with 27 million shares outstanding and a stock price

of $15 per share. Although investors currently expect MAK to remain an all-equity firm, MAK
plans to announce that it will borrow $65 million and use the funds to repurchase shares. MAK
will pay interest only on this debt, and it has no further plans to increase or decrease the amount
of debt. MAK is subject to a 38% corporate tax rate.
a. What is the market value of MAK’s existing assets before the announcement?
b. What is the market value of MAK’s assets (including any tax shields) just after the debt is
issued, but before the shares are repurchased?
c. What is MAK’s share price just before the share repurchase? How many shares will MAK
repurchase?
d. What are MAK’s market value balance sheet and share price after the share repurchase?
a. Assets = Equity = $15 × 27 = $405 million
b. Assets = 405 (existing) + 65 (cash) + 38% × 65 (tax shield) = $494.7 million

c. E = Assets – Debt = 494.7 – 65 = $429.7 million. Share price .

MAK will repurchase million shares.

d. Assets = 405 (existing) + 38% 65 (tax shield) = $429.7 million
Debt = $65 million
E = A – D = 429.7 − 65 = $364.7 million

Share price .
Question: Valuation and Replacement of machine

Polybed Ltd., is one of the earliest innovators in bed manufacturing, and is a leading manufacturer of
moulded beds, selling 3000 beds per year. The selling price of a moulded bed was Rs. 5000 and the
manufacturing cost of a bed was Rs. 3000 during the year that just got over. SGA expensed comes to
10% of sales revenue. Both prices and costs increase by 10% annually. The beds are currently
manufactured using machines from Jarmani that were purchased long time back and are fully
depreciated. These machines are built to last for ever if they are maintained well . Polybed’s
engineers had been sent to Jarmani for training to maintain these machines and have been doing a
great job of keeping these machines performing as when they were brand new. Net working capital
is 10% of sales revenue. Polybed had Rs. 50 lakhs in loans at 10% interest rate. The market value of
land and building owned by Polybed is Rs. 30 lakhs and all of it is used in the business, and given the
advantages due to the proximity to its large customers, the firm is not considering moving its
location. The product has good demand and current trends suggest that revenues will continue to
grow at the current rate for ever.

a) Sanjeev Lochan, the owner of Polybed, has been told by investment bankers that it would be a
good idea to list the firm on the stock exchange. Lochan would like you to value Polybed. Provide an
estimate of the value of Polybed given its current capacity of 3000 beds. Assume after tax weighted
average cost of capital of 15%. Polybed had a tax rate of 30%.

Polybed 0 1 2
No. 3000 3000 3000
Price 5000 5500 6050

Revenue 15,000,000.00 16,500,000.00 18,150,000.00 1 mark

Cost/bed 3000 3300 3630
COGS 9000000 9900000 10890000 1 mark
SGA 1500000 1650000 1815000
PBDIT 4500000 4950000 5445000
Tax 1350000 1485000 1633500
PAT 3150000 3465000 3811500 1 mark
NWK 1500000 1650000 1815000
Investment in NWK   150000 165000 1 mark
CF   3315000 3646500
growth rate     0.1
$
PV 66,300,000     1 mark
Value of land and building need not be
considered as these are fully used for the
business and sell and relocate is not an
option.
b) The moulded machine manufacturer from Jarmani has now developed an improved machine. The
new machine costs Rs. 10 million but it reduces cost of manufacturing to 2/3 of the earlier machine.
The production capacity is the same.This machine is also built to last for ever. SGA will continue to
be 10% of revenue and net working capital will continue to be 10% of revenues. As part of the fiscal
stimulus package, the government has allowed firms to depreciate new investments in machinery on
a straight line basis over 2 years. The machine can be set-up very quickly, and production can start
immediately on the new machine. The old machine will have to be scrapped but it has no salvage
value. Should Polybed invest in the new machine? What will be the impact of this new investment
on the value of Polybed?

Shorter calculations:
Polybed 0 1 2 3 4 5

4,392,30
Saving in COGS   3,300,000 3,630,000 3,993,000 0 4,831,530 1 mark

Saving in COGS(after 3,074,61

tax)   2,310,000 2,541,000 2,795,100 0 3,382,071 1mark
Depreciation tax
shield   1,500,000 1,500,000 - - - 1 mark

3,074,61
After tax cash flow   3,810,000 4,041,000 2,795,100 0 3,382,071

growth rate     0.06 (0.31) 0.10 0.10

(10,000,000
Investment )          

(10,000,000 3,074,61
CF ) 3,810,000 4,041,000 2,795,100 0 3,382,071 1 mark

PV 38,638,563           1 mark

PV 38,638,563

Value of Polybed 104,938,563 1 mark

The NPV of investing in the new machine based on incremental cash flow is Rs. 38.6 million, so
invest.

The value of the firm will be 66.3 + 38.6 = Rs. 104.9 million
Question 3 Assume that the CAPM and Modigliani & Miller hold. Veshti Clothing is in the garment
business, having both manufacturing and retailing operations. Veshti is unlisted, and privately held.
Mr. Varun Veshti, CEO, of Veshti Clothing, has hired you as a financial analyst for the firm and would
like you to estimate the cost of equity for Veshti Clothing. Veshti Clothing is an all India brand with a
significant market share. Veshti’s debt to equity ratio is 0.2 and its debt beta is 0.1. Since Veshti is
unlisted, the challenge was to identify firms that were very similar to Veshti Clothing and estimate
beta of the industry. Information about two firms in the industry having characteristics similar to
Veshti Clothing is provided below:

Name of firm Beta of equity Debt/Equity ratio

Prowear 1.5 1.5

Klothing 1.0 0.5

In order to encourage the textile sector, the government has declared that the sector is a tax free
sector. The risk free rate is 5% and the market risk premium is 10%. Given the high debt to equity
ratio of Prowear and Klothing, the debt issued by these firms cannot be considered risk-free;
furthermore, the beta of debt of Prowear is twice the beta of debt of Klothing.

(a) Provide an estimate of the beta of asset for the industry

Solving simultaneously, Beta of debt of Klothing is 0.0805 and beta of asset is 0.6966.

(b) Provide an estimate for the cost of equity for Veshti Clothing.
Beta equity of Veshti = 0.8159 = 0.6966 + 0.2(0.6966 – 0.1)

rE of Veshti = 5% + 0.8159 x 10% = 13.16%