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PROBLEM 1:
Hick Limited is considering investing in a new project, for which the following information is
available:
£000
Year 1 150
Year 2 300
Year 3 100
Year 4 100
Residual value 30
Required:
Evaluate the financial viability of the above project using the following techniques:
i) payback
ii) the accounting rate of return
iii) net present value (assuming a cost of capital 10%)
iv) internal rate of return
SOLUTION 1:
a.
Time value of money relates to the idea that £ 1 today is not equal in value to £1 in the
future
Time value of money is said to have three components
o The impatience to consume or pure time value of money
o Inflation
o Risk
Therefore it is not appropriate to simply add or compare £s from different time periods
Future £s are therefore translated into present value
b.
(ii)
(iii)
Rearranging gives:
A project requires an initial investment of £120,000 and is expected to produce the following net
cash inflows:
Year 1 £50,000
Year 2 £25,000
Year 3 £25,000
Year 4 £25,000
Year 5 £30,000
Evaluate the financial viability of this project using the following methods:
a) payback
b) accounting rate of return
c) net present value
d) internal rate of return
SOLUTION 2:
a.
(i) Cash flow Cumulative
Investment = (120,000) (120,000)
Year 1 = 50,000 (70,000)
Year 2 = 25,000 (45,000)
Year 3 = 25,000 (20,000)
Year 4 = 25,000 5,000 payback
Therefore payback = 3.8 years (3 years + 20,000/25,000)
(ii)
(iii)
(iv)
Rearranging gives:
6.3 x 0.07
(x - 0.08) =
6.3 + 12.0
PROBLEM 1:
Project Poldavia
A building materials company has identified an opportunity to invest in a new cement plant in
Poldavia, details of which are provided below:
The amount of sustaining capital expenditure required is estimated to be equal to the amount of
depreciation charged per annum.
The Poldavia plant will initially impact on the business of the Company's plant in nearby
Polgaria. It is estimated that the lost exports to Poldavia will result in lost contribution (before
tax) to the Polgarian plant of €8m in year 1, €8m in year 2 and €3m in year 3.
The investment will partly be financed by a 10-year bank loan of €30m at an interest rate of 5%
before tax.
In addition to the €40m capital investment required, a number of feasibility and market
research studies have already been carried out at a total cost of €2m.
Requirement
Calculate the net present value of this investment. (You may assume that the new Poldavia
plant will have an infinite life, even though it will be depreciated over 20 years for accounting
and tax purposes).
SOLUTION 1:
Project Poldavia
Initial investment
(40,000)
Add depreciation 2,000 2,000 2,000 2,000 2,000 2,000
Less sustaining capex, (2,000) (2,000) (2,000) (2,000) (2,000) (2,000)
(working 1)
Free cash flow
Terminal value (working 2) (50,000) (500).. (175) 3,666 7,745 8,810 8,810
103,647
Total amount to discount (50,000) (500) (175) 3,666 7,745 112,457
2. Terminal value
Terminal value = stabilized cash flow x (1 + growth rate)/ (discount rate - growth rate)
Therefore:
PROBLEM 2:
ECF can invest £5 million in a new plant for producing invisible makeup. The plant has an
expected life of 5 years, and expected sales are 6 million jars of makeup a year. Fixed costs are
£2million a year, and variable costs are £1 per jar. The product will be price at £2 per jar. The
plant will be depreciated straight-line over 5 years to a salvage value of zero. The opportunity
cost of capital is 10%, and the tax rate is 40%.
c. What is NPV if fixed costs turn out to be £1.5 million per year?
ECF
After tax cash flow = profit after tax + depreciation = £1.8m + £1 m = £2.8m
a. NPV = -£5 million + [£2.8 million x annuity factor (10%, 5 years)]
= -5 + (2.8 3.791) = £5.6 million
Diamond Ltd
Diamond Ltd has £1m to invest and have identified the following four projects:
Required
Assuming each project is infinitely divisible and the projects are not mutually exclusive, in
which projects should Diamond Ltd invest?
SOLUTION 3:
Diamond Ltd
You are the international financial analyst of a UK MNC. The finance director has asked you to consider the
proposal to acquire a subsidiary in the United States (US) which manufactures personal computers (PCs).
To assess the project, you have been given the following details:
1) An initial capital outlay (for plant and equipment) of USD45 million is to be provided by the UK
MNC at the current spot rate of USD1.6000 to one pound. A further, USD25 million will be
required for working capital and will be borrowed from a local (US) bank. The interest on the loan
is at 10% p.a. The principal of the loan will be repaid in seven years.
The local debt is expected to increase the parent's debt level by an equivalent amount of pounds.
The foreign subsidiary will be sold at the end of the third year in which case the acquiring firm will
take responsibility for the repayment of the loan. Working capital will not be liquidated. The sale of
the subsidiary is expected to generate USD45 million after capital gains taxes. The UK MNC
requires an all-equity nominal rate of return of 15 per cent on the project. This rate is already
adjusted for the country risk associated with the project.
2) The expected turnover and variable costs arising from the sale and production of the PCs are as
follows:
3) Fixed overheads (excluding depreciation) are estimated to be USD 5 million per year. Plant and
equipment will be depreciated over 7.2 years on a straight-line basis.
4) The foreign exchange rate forecasts of the USD against the pound at the end of each year are as
follows: Year 1: USD 1.6500; Year 2: USD 1.6300; and Year 3: USD 1.6800.
5) The local corporation tax is 30%. In addition, a withholding tax of 10% is imposed on all cash flows
that are remitted to the parent. The UK government will allow the tax credit on remitted cash flows
and will not impose an additional tax. All net cash flows that are generated by the subsidiary's
operations will be remitted to the parent at the end of each year and the subsidiary will maintain the
level of its working capital to support ongoing operations.
Required:
Note that most of the calculations have been performed using a spreadsheet; there will therefore be some problems with
rounding errors when (say) a calculator is used.
a) Year 0 1 2 3
Revenue 20,000,000 19,150,000 25,900,000
Variable cost 1,300,000 3,550,000 2,800,000
Fixed cost 5,000,000 5,000,000 5,000,000
Depreciation 6,250,000 6,250,000 6,250,000
Before tax earnings 7,450,000 4,350,000 11,850,000
Host Govt tax @30% 2,235,000 1,305,000 3,555,000
Earnings after tax 5,215,000 3,045,000 8,295,000
Add depreciation 6,250,000 6,250,000 6,250,000
Amount to be remitted 11,465,000 9,295,000 14,545,000
To parent after W/holding tax @10% 10,318,500 8,365,500 13,090,500
Salvage value 45,000,000
Capital outlay (45,000,000)
NCF in USD (45,000,000) 10,318,500 8,365,500 58,090,500
FX rates 1.6000 1.6500 1.6300 1.6800
NCF in GBP (28,125,000) 6,253,636 5,132,209 34,577,679
DF 1.000 0.870 0.756 0.658
PV in GBP (28,125,000) 5,437,945 3,880,687 22,735,385
Cumulative PV (28,125,000) (22,687,055) (18,806,368) 3,929,017
Base-case (all-equity) NPV in GBP 3,929,017