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1 / 6

SECTION A: THIS QUESTION is compulsory and MUST be attempted

 

QUESTION 01- KENDWE

Kendwe, whose currency is the Kendwe Rand (KR), 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 Kendwe'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 Kendwe 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 Kendwe'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 Kendwe'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%

 

Kendwe'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:

  1. Zero corporation tax payable in the first two years of operation; and
  2. 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 Kendwe prime locations in towns and cities with good transport links.

 

Yung Co

Yung Co, a large listed company based in the US 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, Yung Co is considering setting up an assembly plant in Kendwe where parts would be sent and assembled into a specific type of component, which is currently being assembled in the US. 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 Kendwe: 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 Kendwe'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        
Sales component units ('000) 150 480 730 360

 

The parts needed to assemble into the components in Kendwe will be sent from the US by Yung Co at a cost of $200 per component unit, from which Yung Co would currently earn a pre-tax contribution of $40 for each component unit. However, Yung Co feels that it can negotiate with Kendwe's Government and increase the transfer price to $280 per component unit. The variable costs related to assembling the components in Kendwe 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.

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

Yung Co will expect annual royalties from the assembly plant to be made every year. The normal annual royalty fee is currently $20 million, but Yung Co feels that it can negotiate this with Kendwe'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 Yung Co does decide to invest in an assembly plant in Kendwe, its exports from the US to the EU will fall and it will incur redundancy costs. As a result, Yung 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

 

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

 

Other financial information

Current spot rates

Euro per dollar €0.714/$1
KR per euro KR142/€1
KR per dollar KR101.4/$1

 

Forecast future rates based on expected inflation rate differentials

Year 1 2 3 4
KR/$1 120.1 133.7 142.5 151.9

 

Year 1 2 3 4
KR/€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%
US expected inflation rate: Year 1 onwards 3%

 

Required

a. Discuss the possible benefits and drawbacks to Yung Co of setting up its own assembly plant in Kendwe, compared to licensing a company based in Kendwe to undertake the assembly on its behalf.

(5 marks)

2 / 6

b. Prepare a report which:

 

i. Evaluates the financial acceptability of the investment in the assembly plant in Kendwe

(21 marks)

 

ii. Discusses the assumptions made in producing the estimates, and the other risks and issues which Yung Co should consider before making the final decision.

(17 marks)

 

iii. Provides a reasoned recommendation on whether or not Yung Co should invest in the assembly plant in Kendwe

(3 marks)

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

(4 marks)

3 / 6

SECTION B: BOTH QUESTIONS TO BE ATTEMPTED

 

QUESTION 02- BROWN CO

You have recently commenced working for Brown Co and are reviewing a four-year project which the company is considering for investment. The project is in a business activity which is very different from Brown Co’s current line of business.

The following net present value estimate has been made for the project: All figures are in $ million

Year 0 1 2 3 4
Sales revenue   23.03 36.60 49.07 27.14
Direct project costs   (13.82) (21.96) (29.44) (16.28)
Interest   (1.20)

––––––

(1.20)

––––––

(1.20)

––––––

(1.20)

––––––

Profit   8.01 13.44 18.43 9.66
Tax (20%)   (1.60) (2.69) (3.69) (1.93)
Investment/sale (38.00)       4.00
Cash flows (38.00)

––––––

6.41

––––––

10.75

––––––

14.74

––––––

11.73

––––––

Discount factors (7%) 1

––––––

0.935

––––––

0.873

––––––

0.816

––––––

0.763

––––––

Present values (38.00)

––––––

5.99

––––––

9.38

––––––

12.03

––––––

8.95

––––––

 

Net present value is negative $1.65 million, and therefore the recommendation is that the project should not be accepted.

 

Notes to NPV appraisal

 

In calculating the net present value of the project, the following notes were made:

Since the real cost of capital is used to discount cash flows, neither the sales revenue nor the direct project costs have been inflated. It is estimated that the inflation rate applicable to sales revenue is 8% per year and to the direct project costs is 4% per year.

The project will require an initial investment of $38 million. Of this, $16 million relates to plant and machinery, which is expected to be sold for $4 million when the project ceases, after taking any taxation and inflation impact into account.

Tax allowable depreciation is available on the plant and machinery at 50% in the first year, followed by 25% per year thereafter on a reducing balance basis. A balancing adjustment is available in the year the plant and machinery is sold. Brown Co pays 20% tax on its annual taxable profits. No tax allowable depreciation is available on the remaining investment assets and they will have a nil value at the end of the project.

Brown Co uses either a nominal cost of capital of 11% or a real cost of capital of 7% to discount all projects, given that the rate of inflation has been stable at 4% for a number of years.

Interest is based on Brown Co’s normal borrowing rate of 150 basis points over the 10-year government yield rate.

At the beginning of each year, Brown Co will need to provide working capital of 20% of the anticipated sales revenue for the year. Any remaining working capital will be released at the end of the project.

Working capital and depreciation have not been taken into account in the net present value calculation above, since depreciation is not a cash flow and all the working capital is returned at the end of the project.

 

Further financial information

It is anticipated that the project will be financed entirely by debt, 60% of which will be obtained from a subsidised loan scheme run by the government, which lends money at a rate of 100 basis points below the 10-year government debt yield rate of 2.5%. Issue costs related to raising the finance are 2% of the gross finance required. The remaining 40% will be funded from Brown Co’s normal borrowing sources. It can be assumed that the debt capacity available to Brown Co is equal to the actual amount of debt finance raised for the project.

Brown Co has identified a company, Flint Co, which operates in the same line of business as that of the project it is considering. Flint Co is financed by 40 million shares trading at $3.20 each and $34 million debt trading at $94 per $100. Flint Co’s equity beta is estimated at 1.5. The current yield on government treasury bills is 2% and it is estimated that the market risk premium is 8%. Flint Co pays tax at an annual rate of 20%.

Both Brown Co and Flint Co pay tax in the same year as when profits are earned.

 

Required:

a. Calculate the adjusted present value (APV) for the project, correcting any errors made in the net present value estimate above, and conclude whether the project should be accepted or not. Show all relevant calculations.

(15 marks)

4 / 6

b. Comment on the corrections made to the original net present value estimate and explain the APV approach taken in part (a), including any assumptions made.

(10 marks)

5 / 6

QUESTION 03- AMBER CO

Amber Co is a listed company with divisions which manufacture cars, motorbikes and cycles. Over the last few years, Amber Co has used a mixture of equity and debt finance for its investments. However, it is about to make a new investment of $150 million in facilities to produce electric cars, which it proposes to finance solely by debt finance.

 

Project information

Amber Co's finance director has prepared estimates of the post-tax cash flows for the project, using a four-year time horizon, together with the realisable value at the end of four years:

Year 1

$m

2

$m

3

$m

4

$m

Post-tax operating cash flows 28.50 36.70 44.40 50.90
Realisable value       45.00

 

Working capital of $6 million, not included in the estimates above and funded from retained earnings, will also be required immediately for the project, rising by the predicted rate of inflation for each year. Any remaining working capital will be released in full at the end of the project.

 

Predicted rates of inflation are as follows:

Year 1 2 3 4
  8% 6% 5% 4%

 

The finance director has proposed the following finance package for the new investment:

  $m
Bank loan, repayable in equal annual instalments over the project's life, interest payable at 8% per year 70
Subsidised loan from a government loan scheme over the project's life on which interest is payable at 3.1% per year 80

____

  150

____

 

Issue costs of 3% of gross proceeds will be payable on the subsidised loan. No issue costs will be payable on the bank loan. Issue costs are not allowable for tax.

 

Financial information

Amber Co pays tax at an annual rate of 30% on profits in the same year in which profits arise.

Amber Co's asset beta is currently estimated at 1.14. The current return on the market is estimated at 11%. The current risk-free rate is 4% per year.

Amber Co's chairman has noted that all of the company's debt, including the new debt, will be repayable within three to five years. He is wondering whether Amber Co needs to develop a longer-term financing policy in broad terms and how flexible this policy should be.

 

Required

a. Calculate the adjusted present value (APV) for the project and conclude whether the project should be accepted or not.

(15 marks)

6 / 6

b. Discuss the factors which may determine the long-term finance policy which Amber Co's board may adopt and the factors which may cause the policy to change.

(10 marks)

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