FIN208: Corporate Finance

Tutorial 4

Question 1:

TSM has started a new project with the exclusive production rights for digital mini camera in
Taiwan. Production facilities for 200,000 units per year will require a TWD$25 millions immediate
capital expenditure. Production costs are estimated at $65 per unit. The marketing manager is
confident that all 200,000 units can be sold for $100 per unit until the patent runs out. After that
the marketing manager hasn’t a clue about what the selling price will be. Given the following data:

 Cost of capital is 9 percent

 Assume the capital, production costs and technology will all remain unchanged.
 Competitors know the technology and can enter as soon as the patent expires in year 6 so that
in year 7 and onward, ROE of the project would be the same as the cost of capital.
 The production (full production) begins after 12 months.
 Assume no taxes.
 The production facilities last 12 years. No salvage value at the end of the useful life.

(i) From the above, estimate the selling price of the product after the expiration of the patent.

(ii) Find the NPV of the above project.

(iii) If the above project causes the sales revenues of other existing products of the firm to decline
by $1 million per year, what will be the effect of this cannibalization on the NPV of this project?
Compute the adjusted NPV for cannibalization.

Question 2:

Ranhill is considering a capital project with the following characteristics:

The initial outlay is $180,000 with the project life of three years. Annual after-tax operating cash
flows have a 50 percent probability of being $50,000 for the three years and a 50 percent
probability of being $100,000 with the assumption that the salvage value at project termination is
zero. The required rate of return for the project is 15 percent.

Suppose that in one year, after realizing the first-year cash flow, the company has the option to
abandon the project and receive the salvage value of $110,000.
 i) Compute the project NPV assuming no abandonment.
ii) Compute the project NPV using the abandonment strategy.

Question 3:

Putra Suria Plumbing is a wholesale plumbing supply store. The store currently generates revenues
of $1 million per year. Next year, revenue will either decrease by 10% or increase by 5%, with
equal probability, and then stay at that level as long as you operate the store. You own the store
outright. Total costs of running the store are $900,000 per year. You have the option to shut down
the store if the business is unfavourable. There are no costs to shutting down and you can always
sell the store for $500,000 in that case. Assume that the cost of capital is 10%.

(i) Calculate the total value of the business today without considering the option that
you have.

(ii) Calculate the total value of the business today with the above option that you have
and determine the value of the option.

Question 4:

a) The table below shows a condensed income statement and balance sheet for Malaysia Aica
Berhad:

Balance Sheet and Income Statement for Malaysia Aica (in $million):
Income Statement for 2016 Assets, 31 December, 2016
Sales Revenue 256.66 Net working capital $27.08
Raw Material cost 58.72
Operating Costs 71.09 Investment in plant and equipment 269.33
Depreciation 34.50 Less accumulated depreciation 121.01
Earnings Before Interest and 92.35 Net plant and equipment 148.32
Taxes (EBIT)
Interest expense 22.00
Earnings Before Taxes (EBT) 70.35
Taxes at 28% 19.70
Net Earnings $50.65 Total assets 175.40

Notes:
 Malaysia Aica is principally engaged in the design and manufacture of automated material
handling systems and factory automation systems. Many of its new designs for the material
handling system and automation systems are patented. The average lifespan of the patents
is eight years and Malaysia Aica has been offered $20 million for all the patent rights.
  As the above table shows, the plant is carried on Malaysia Aica’s net books at $148.32
million. However, it is a modern design, and could be sold to its peer group company for
$200 million.

 The cost of capital for Malaysia Aica is 9 percent.

i) Based on the above Financial Statements and the information from the Notes, calculate the
Economic Value Added (EVA) for Malaysia Aica Berhad.

ii) Suppose all the plant and division managers of Malaysia Aica were paid only a fixed salary
without any incentives or bonuses. Give three examples of the agency problems that might
appear in the capital investment decisions within Malaysia Aica.

iii) Evaluate the pros and cons of EVA in measuring the financial performance of managers
and determining their compensation.

Question 5:

“A project is not a black box. Senior managers must know where the positive NPVs come from.
Otherwise they will be continuously bombarded with requests for funds for capital expenditures.
Senior managers must know whether the projects are proposed by them because they have positive
NPVs or do they have positive NPVs because they are proposed.”

Discuss the above statement in the light of the sources of positive NPV in capital investments.

Question 6: Which of the following competitive advantages is the most unlikely to be

sustainable over the time?
A. economies of scale
B. brand names
C. licensing
D. economies of scope

Question 7: Which of the following statements most appropriately describes "Sensitivity

Analysis".
A. it looks at different but consistent combination of variables
B. it provides the break-even level of sales for the project
C. it looks at the project by changing one variable at a time
D. A&B