NPV 1 / 14

Sample
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Question 2a

Fernhurst Co is a manufacturer of mobile communications technology. It is about to launch a new communications device, the Milland, which its directors believe is both more technologically advanced and easier to use than devices currently offered by its rivals.

Investment in the Milland
The Milland will require a major investment in facilities. Fernhurst Co’s directors believe that this can take place very quickly and production be started almost immediately.

Fernhurst Co expects to sell 132,500 units of the Milland in its first year. Sales volume is expected to increase by 20% in Year 2 and 30% in Year 3, and then be the same in Year 4 as Year 3, as the product reaches the end of its useful life. The initial selling price in Year 1 is expected to be $100 per unit, before increasing with the rate of inflation annually.

The variable cost of each unit is expected to be $43·68 in year 1, rising by the rate of inflation in subsequent years annually. Fixed costs are expected to be $900,000 in Year 1, rising by the rate of inflation in subsequent years annually.

The initial investment in non-current assets is expected to be $16,000,000. Fernhurst Co will also need to make an immediate investment of $1,025,000 in working capital. The working capital will be increased annually at the start of each of Years 2 to 4 by the inflation rate and is fully recoverable at the end of the project’s life. Fernhurst Co will also incur one-off marketing expenditure of $1,500,000 post inflation after the launch of the Milland. The marketing expenditure can be assumed to be made at the end of Year 1 and be a tax allowable expense.

Fernhurst Co pays company tax on profits at an annual rate of 25%. Tax is payable in the year that the tax liability arises. Tax allowable depreciation is available at 20% on the investment in non-current assets on a reducing balance basis. A balancing adjustment will be available in Year 4. The realisable value of the investment at the end of Year 4 is expected to be zero.

The expected annual rate of inflation in the country in which Fernhurst Co is located is 4% in Year 1 and 5% in
Years 2 to 4.

The applicable cost of capital for this investment appraisal is 11%.

Other calculations
Fernhurst Co’s finance director has indicated that besides needing a net present value calculation based on this data for the next board meeting, he also needs to know the figure for the project’s duration, to indicate to the board how returns from the project will be spread over time.

Failure of launch of the Milland
The finance director would also like some simple analysis based on the possibility that the marketing expenditure is not effective and the launch fails, as he feels that the product’s price may be too high. He has suggested that there is a 15% chance that the Milland will have negative net cash flows for Year 1 of $1,000,000 or more. He would like to know by what percentage the selling price could be reduced or increased to result in the investment having a zero net present value, assuming demand remained the same.

Assessment of new products
Fernhurst Co’s last board meeting discussed another possible new product, the Racton, and the finance director presented a range of financial data relating to this product, including the results of net present value and payback evaluations. One of the non-executive directors, who is not a qualified accountant, stated that he found it difficult to see the significance of the different items of financial data. His understanding was that Fernhurst Co merely had to ensure that the investment had a positive net present value and shareholders were bound to be satisfied with it, as it would maximise their wealth in the long term. The finance director commented that, in reality, some shareholders looked at the performance of the investments which Fernhurst Co made over the short term, whereas some were more concerned with the longer term. The financial data he presented to board meetings included both short and long-term measures.

Required:
(a) Evaluate the financial acceptability of the investment in the Milland and, calculate and comment on the investment’s duration. (15 marks)

Sample
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Question 2b

Fernhurst Co is a manufacturer of mobile communications technology. It is about to launch a new communications device, the Milland, which its directors believe is both more technologically advanced and easier to use than devices currently offered by its rivals.

Investment in the Milland
The Milland will require a major investment in facilities. Fernhurst Co’s directors believe that this can take place very quickly and production be started almost immediately.

Fernhurst Co expects to sell 132,500 units of the Milland in its first year. Sales volume is expected to increase by 20% in Year 2 and 30% in Year 3, and then be the same in Year 4 as Year 3, as the product reaches the end of its useful life. The initial selling price in Year 1 is expected to be $100 per unit, before increasing with the rate of inflation annually.

The variable cost of each unit is expected to be $43·68 in year 1, rising by the rate of inflation in subsequent years annually. Fixed costs are expected to be $900,000 in Year 1, rising by the rate of inflation in subsequent years annually.

The initial investment in non-current assets is expected to be $16,000,000. Fernhurst Co will also need to make an immediate investment of $1,025,000 in working capital. The working capital will be increased annually at the start of each of Years 2 to 4 by the inflation rate and is fully recoverable at the end of the project’s life. Fernhurst Co will also incur one-off marketing expenditure of $1,500,000 post inflation after the launch of the Milland. The marketing expenditure can be assumed to be made at the end of Year 1 and be a tax allowable expense.

Fernhurst Co pays company tax on profits at an annual rate of 25%. Tax is payable in the year that the tax liability arises. Tax allowable depreciation is available at 20% on the investment in non-current assets on a reducing balance basis. A balancing adjustment will be available in Year 4. The realisable value of the investment at the end of Year 4 is expected to be zero.

The expected annual rate of inflation in the country in which Fernhurst Co is located is 4% in Year 1 and 5% in
Years 2 to 4.

The applicable cost of capital for this investment appraisal is 11%.

Other calculations
Fernhurst Co’s finance director has indicated that besides needing a net present value calculation based on this data for the next board meeting, he also needs to know the figure for the project’s duration, to indicate to the board how returns from the project will be spread over time.

Failure of launch of the Milland
The finance director would also like some simple analysis based on the possibility that the marketing expenditure is not effective and the launch fails, as he feels that the product’s price may be too high. He has suggested that there is a 15% chance that the Milland will have negative net cash flows for Year 1 of $1,000,000 or more. He would like to know by what percentage the selling price could be reduced or increased to result in the investment having a zero net present value, assuming demand remained the same.

Assessment of new products
Fernhurst Co’s last board meeting discussed another possible new product, the Racton, and the finance director presented a range of financial data relating to this product, including the results of net present value and payback evaluations. One of the non-executive directors, who is not a qualified accountant, stated that he found it difficult to see the significance of the different items of financial data. His understanding was that Fernhurst Co merely had to ensure that the investment had a positive net present value and shareholders were bound to be satisfied with it, as it would maximise their wealth in the long term. The finance director commented that, in reality, some shareholders looked at the performance of the investments which Fernhurst Co made over the short term, whereas some were more concerned with the longer term. The financial data he presented to board meetings included both short and long-term measures.

Required:
(b) Calculate the % change in the selling price required for the investment to have a zero net present value, and discuss the significance of your results. (5 marks)

Sample
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Question 2c

Fernhurst Co is a manufacturer of mobile communications technology. It is about to launch a new communications device, the Milland, which its directors believe is both more technologically advanced and easier to use than devices currently offered by its rivals.

Investment in the Milland
The Milland will require a major investment in facilities. Fernhurst Co’s directors believe that this can take place very quickly and production be started almost immediately.

Fernhurst Co expects to sell 132,500 units of the Milland in its first year. Sales volume is expected to increase by 20% in Year 2 and 30% in Year 3, and then be the same in Year 4 as Year 3, as the product reaches the end of its useful life. The initial selling price in Year 1 is expected to be $100 per unit, before increasing with the rate of inflation annually.

The variable cost of each unit is expected to be $43·68 in year 1, rising by the rate of inflation in subsequent years annually. Fixed costs are expected to be $900,000 in Year 1, rising by the rate of inflation in subsequent years annually.

The initial investment in non-current assets is expected to be $16,000,000. Fernhurst Co will also need to make an immediate investment of $1,025,000 in working capital. The working capital will be increased annually at the start of each of Years 2 to 4 by the inflation rate and is fully recoverable at the end of the project’s life. Fernhurst Co will also incur one-off marketing expenditure of $1,500,000 post inflation after the launch of the Milland. The marketing expenditure can be assumed to be made at the end of Year 1 and be a tax allowable expense.

Fernhurst Co pays company tax on profits at an annual rate of 25%. Tax is payable in the year that the tax liability arises. Tax allowable depreciation is available at 20% on the investment in non-current assets on a reducing balance basis. A balancing adjustment will be available in Year 4. The realisable value of the investment at the end of Year 4 is expected to be zero.

The expected annual rate of inflation in the country in which Fernhurst Co is located is 4% in Year 1 and 5% in
Years 2 to 4.

The applicable cost of capital for this investment appraisal is 11%.

Other calculations
Fernhurst Co’s finance director has indicated that besides needing a net present value calculation based on this data for the next board meeting, he also needs to know the figure for the project’s duration, to indicate to the board how returns from the project will be spread over time.

Failure of launch of the Milland
The finance director would also like some simple analysis based on the possibility that the marketing expenditure is not effective and the launch fails, as he feels that the product’s price may be too high. He has suggested that there is a 15% chance that the Milland will have negative net cash flows for Year 1 of $1,000,000 or more. He would like to know by what percentage the selling price could be reduced or increased to result in the investment having a zero net present value, assuming demand remained the same.

Assessment of new products
Fernhurst Co’s last board meeting discussed another possible new product, the Racton, and the finance director presented a range of financial data relating to this product, including the results of net present value and payback evaluations. One of the non-executive directors, who is not a qualified accountant, stated that he found it difficult to see the significance of the different items of financial data. His understanding was that Fernhurst Co merely had to ensure that the investment had a positive net present value and shareholders were bound to be satisfied with it, as it would maximise their wealth in the long term. The finance director commented that, in reality, some shareholders looked at the performance of the investments which Fernhurst Co made over the short term, whereas some were more concerned with the longer term. The financial data he presented to board meetings included both short and long-term measures.

Required:
(c) Discuss the non-executive director’s understanding of net present value and explain the importance of other measures in providing data about an investment’s short and long-term performance. (5 marks)

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Question 1b

Yilandwe
Yilandwe, whose currency is the Yilandwe Rand (YR), has faced extremely difficult economic challenges in the past 25 years because of some questionable economic policies and political decisions made by its previous governments. Although Yilandwe’s population is generally poor, its people are nevertheless well-educated and ambitious. Just over three years ago, a new government took office and since then it has imposed a number of strict monetary and fiscal controls, including an annual corporation tax rate of 40%, in an attempt to bring Yilandwe out of its difficulties. As a result, the annual rate of inflation has fallen rapidly from a high of 65% to its current level of 33%. These strict monetary and fiscal controls have made Yilandwe’s government popular in the larger cities and towns, but less popular in the rural areas which seem to have suffered disproportionately from the strict monetary and fiscal controls.

It is expected that Yilandwe’s annual inflation rate will continue to fall in the coming few years as follows:

Year Inflation rate
1 22·0%
2 14·7%
3 onwards 9·8%

Yilandwe’s government has decided to continue the progress made so far, by encouraging foreign direct investment into the country. Recently, government representatives held trade shows internationally and offered businesses a number of concessions, including:

(i) zero corporation tax payable in the first two years of operation; and
(ii) an opportunity to carry forward tax losses and write them off against future profits made after the first two years.

The government representatives also promised international companies investing in Yilandwe prime locations in towns and cities with good transport links.

Imoni Co
Imoni Co, a large listed company based in the USA with the US dollar ($) as its currency, manufactures high tech diagnostic components for machinery, which it exports worldwide. After attending one of the trade shows, Imoni Co is considering setting up an assembly plant in Yilandwe where parts would be sent and assembled into a specific type of component, which is currently being assembled in the USA. Once assembled, the component will be exported directly to companies based in the European Union (EU). These exports will be invoiced in Euro (€).

Assembly plant in Yilandwe: financial and other data projections
It is initially assumed that the project will last for four years. The four-year project will require investments of YR21,000 million for land and buildings, YR18,000 million for machinery and YR9,600 million for working capital to be made immediately. The working capital will need to be increased annually at the start of each of the next three years by Yilandwe’s inflation rate and it is assumed that this will be released at the end of the project’s life.

It can be assumed that the assembly plant can be built very quickly and production started almost immediately. This is because the basic facilities and infrastructure are already in place as the plant will be built on the premises and grounds of a school. The school is ideally located, near the main highway and railway lines. As a result, the school will close and the children currently studying there will be relocated to other schools in the city. The government has kindly agreed to provide free buses to take the children to these schools for a period of six months to give parents time to arrange appropriate transport in the future for their children.

The current selling price of each component is €700 and this price is likely to increase by the average EU rate of inflation from year 1 onwards.

The number of components expected to be sold every year are as follows:

Year 1 2 3 4
Sales component units (000s) 150 480 730 360

The parts needed to assemble into the components in Yilandwe will be sent from the USA by Imoni Co at a cost of $200 per component unit, from which Imoni Co would currently earn a pre-tax contribution of $40 for each component unit. However, Imoni Co feels that it can negotiate with Yilandwe’s government and increase the transfer price to $280 per component unit. The variable costs related to assembling the components in Yilandwe are currently YR15,960 per component unit. The current annual fixed costs of the assembly plant are YR4,600 million. All these costs, wherever incurred, are expected to increase by that country’s annual inflation every year from year 1 onwards.

Imoni Co pays corporation tax on profits at an annual rate of 20% in the USA. The tax in both the USA and Yilandwe is payable in the year that the tax liability arises. A bilateral tax treaty exists between Yilandwe and the USA. Tax allowable depreciation is available at 25% per year on the machinery on a straight-line basis.

Imoni Co will expect annual royalties from the assembly plant to be made every year. The normal annual royalty fee is currently $20 million, but Imoni Co feels that it can negotiate this with Yilandwe’s government and increase the royalty fee by 80%. Once agreed, this fee will not be subject to any inflationary increase in the project’s four-year period.

If Imoni Co does decide to invest in an assembly plant in Yilandwe, its exports from the USA to the EU will fall and it will incur redundancy costs. As a result, Imoni Co’s after-tax cash flows will reduce by the following amounts:

Year 1 2 3 4
Redundancy and lost contribution 20,000 55,697 57,368 59,089

Imoni Co normally uses its cost of capital of 9% to assess new projects. However, the finance director suggests that
Imoni Co should use a project specific discount rate of 12% instead.

Other financial information

Current spot rates
Euro per Dollar €0·714/$1
YR per EuroYR142/€1
YR per Dollar YR101·4/$1
Forecast future rates based on expected inflation rate differentials
Year 1 2 3 4
YR/$1 120·1 133·7 142·5 151·9
Year 1 2 3 4
YR/€1 165·0 180·2 190·2 200·8
Expected inflation rates
EU expected inflation rate: Next two years 5%
EU expected inflation rate: Year 3 onwards 4%
USA expected inflation rate: Year 1 onwards 3%

Required:
(b) Prepare a report which:

(i) Evaluates the financial acceptability of the investment in the assembly plant in Yilandwe; (21 marks)

(ii) Discusses the assumptions made in producing the estimates, and the other risks and issues which Imoni Co should consider before making the final decision; (17 marks)

(iii) Provides a reasoned recommendation on whether or not Imoni Co should invest in the assembly plant in Yilandwe. (3 marks)

Professional marks will be awarded in part (b) for the format, structure and presentation of the report. (4 marks)

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Question 1c

Nahara Co and Fugae Co
Nahara Co is a private holding company owned by the government of a wealthy oil-rich country to invest its sovereign funds. Nahara Co has followed a strategy of risk diversification for a number of years by acquiring companies from around the world in many different sectors.

One of Nahara Co’s acquisition strategies is to identify and purchase undervalued companies in the airline industry in Europe. A recent acquisition was Fugae Co, a company based in a country which is part of the European Union (EU). Fugae Co repairs and maintains aircraft engines.

A few weeks ago, Nahara Co stated its intention to pursue the acquisition of an airline company based in the same country as Fugae Co. The EU, concerned about this, asked Nahara Co to sell Fugae Co before pursuing any further acquisitions in the airline industry.

Avem Co’s acquisition interest in Fugae Co
Avem Co, a UK-based company specialising in producing and servicing business jets, has approached Nahara Co with a proposal to acquire Fugae Co for $1,200 million. Nahara Co expects to receive a premium of at least 30% on the estimated equity value of Fugae Co, if it is sold.

Given below are extracts from the most recent statements of financial position of both Avem Co and Fugae Co.

Avem Co $ million Fugae Co
Share capital (50c/share) 800 100
Reserves 3,550 160
Non-current liabilities 2,200 380
Current liabilities 130 30
Total capital and liabilities
6,680

670

Each Avem Co share is currently trading at $7·50, which is a multiple of 7·2 of its free cash flow to equity. Avem Co expects that the total free cash flows to equity of the combined company will increase by $40 million due to synergy benefits. After adding the synergy benefits of $40 million, Avem Co then expects the multiple of the total free cash flow of the combined company to increase to 7·5.

Fugae Co’s free cash flow to equity is currently estimated at $76·5 million and it is expected to generate a return on equity of 11%. Over the past few years, Fugae Co has returned 77·3% of its annual free cash flow to equity back to Nahara Co, while retaining the balance for new investments.

Fugae Co’s non-current liabilities consist entirely of $100 nominal value bonds which are redeemable in four years at the nominal value, on which the company pays a coupon of 5·4%. The debt is rated at B+ and the credit spread on B+ rated debt is 80 basis points above the risk-free rate of return.

Proposed luxury transport investment project by Fugae Co
In recent years, the country in which Fugae Co is based has been expanding its tourism industry and hopes that this industry will grow significantly in the near future. At present tourists normally travel using public transport and taxis, but there is a growing market for luxury travel. If the tourist industry does expand, then the demand for luxury travel is expected to grow rapidly. Fugae Co is considering entering this market through a four-year project. The project will cease after four years because of increasing competition.

The initial cost of the project is expected to be $42,000,000 and it is expected to generate the following after-tax cash flows over its four-year life:

Year 1 2 3 4
Cash flows ($000s) 3,277.6 16,134.3 36,504.7 35,683.6

The above figures are based on the tourism industry expanding as expected. However, it is estimated that there is a 25% probability that the tourism industry will not grow as expected in the first year. If this happens, then the present value of the project’s cash flows will be 50% of the original estimates over its four-year life.

It is also estimated that if the tourism industry grows as expected in the first year, there is still a 20% probability that the expected growth will slow down in the second and subsequent years, and the present value of the project’s cash flows would then be 40% of the original estimates in each of these years.

Lumi Co, a leisure travel company, has offered $50 million to buy the project from Fugae Co at the start of the second year. Fugae Co is considering whether having this choice would add to the value of the project.

If Fugae Co is bought by Avem Co after the project has begun, it is thought that the project will not result in any additional synergy benefits and will not generate any additional value for the combined company, above any value the project has already generated for Fugae Co.

Although there is no beta for companies offering luxury forms of travel in the tourist industry, Reka Co, a listed company, offers passenger transportation services on coaches, trains and luxury vehicles. About 15% of its business is in the luxury transport market and Reka Co’s equity beta is 1·6. It is estimated that the asset beta of the non-luxury transport industry is 0·80. Reka Co’s shares are currently trading at $4·50 per share and its debt is currently trading at $105 per $100. It has 80 million shares in issue and the book value of its debt is $340 million. The debt beta is estimated to be zero.

General information
The corporation tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4% and the market risk premium is estimated to be 6%.

Required:
(c) Prepare a report for the Board of Directors of Avem Co, which:

(i) Estimates the additional value created for Avem Co, if it acquires Fugae Co without considering the luxury transport project; (10 marks)

(ii) Estimates the additional value of the luxury transport project to Fugae Co, both with and without the offer from Lumi Co; (18 marks)

(iii) Evaluates the benefit attributable to Avem Co and Fugae Co from combining the two companies with and without the project, and concludes whether or not the acquisition is beneficial. The evaluation should include any assumptions made. (7 marks)

Professional marks will be awarded in part (c) for the format, structure and presentation of the report. (4 marks)

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Question 4a

Arbore Co is a large listed company with many autonomous departments operating as investment centres. It sets investment limits for each department based on a three-year cycle. Projects selected by departments would have to fall within the investment limits set for each of the three years. All departments would be required to maintain a capital investment monitoring system, and report on their findings annually to Arbore Co’s board of directors.

The Durvo department is considering the following five investment projects with three years of initial investment expenditure, followed by several years of positive cash inflows. The department’s initial investment expenditure limits are $9,000,000, $6,000,000 and $5,000,000 for years one, two and three respectively. None of the projects can be deferred and all projects can be scaled down but not scaled up.

ProjectYear one 
(Immediately)   
Year twoYear three Project net
present value
PDur01$4,000,000$1,100,000$2,400,000$464,000
PDur02$800,000$2,800,000$3,200,000$244,000
PDur03$3,200,000$3,562,000$0$352,000
PDur04$3,900,000$0$200,000$320,000
PDur05$2,500,000 $1,200,000$1,400,000Not provided

PDur05 project’s annual operating cash flows commence at the end of year four and last for a period of 15 years. The project generates annual sales of 300,000 units at a selling price of $14 per unit and incurs total annual relevant costs of $3,230,000. Although the costs and units sold of the project can be predicted with a fair degree of certainty, there is considerable uncertainty about the unit selling price. The department uses a required rate of return of 11% for its projects, and inflation can be ignored.

The Durvo department’s managing director is of the opinion that all projects which return a positive net present value should be accepted and does not understand the reason(s) why Arbore Co imposes capital rationing on its departments. Furthermore, she is not sure why maintaining a capital investment monitoring system would be beneficial to the company


Required:

Calculate the net present value of project PDur05. Calculate and comment on what percentage fall in the selling price would need to occur before the net present value falls to zero. (6 marks)

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