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Financial Strategy-Exam Kit

Financial Strategy-Exam Kit

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Published by: Dhanushka Rajapaksha on Jul 11, 2012
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REM is a family-owned business. The family owns 80% of the shares. The remaining
20% is owned by four non-family shareholders. The Board of Directors is consider-
ing the purchase of two second-hand (i.e. previously used) freight planes to deliver
its goods within its key markets in the USA. The Managing Director, an ex-pilot and
one of the non-family shareholders, commissioned an evaluation from the company’s
accountants and was advised that the company would save money and be more effi-
cient if it performed these delivery operations itself instead of ‘outsourcing’ them to
established courier and postal services. The accountants built into their evaluation an
assumption that the company would be able to sell spare capacity on the planes to other
companies in the locality.

The Managing Director has decided that the accountants’ recommendation will be con-
ducted as a ‘trial’ for 5 years when its success or otherwise will be evaluated. The net, post-
tax operating cash flows of this investment are estimated as:




12.50 (the initial capital investment)


3.15 each year



Year 5 includes an estimate of the residual value of the planes.

The company normally uses an estimated post-tax weighted average cost of capital of
12% to evaluate investments. However, this investment is different from its usual busi-
ness operations and the Finance Director suggests using the capital asset pricing model
(CAPM) to determine a discount rate. REM, being unlisted, does not have a published
beta so the Finance Director has obtained a beta of 1.3 for a courier company that is
listed. This company has a debt ratio (debt to equity) of 1:2, compared with REM whose
debt ratio is 1:5.

Other information:

• The expected annual post-tax return on the market is 9% and the risk-free rate is 5%.
• Assume both companies’ debt is virtually risk-free.
• Both companies pay tax at 30%.


(a) Using the CAPM, calculate:

(i) an asset beta for REM
(ii) an equity beta for REM

86 Exam Practice Kit: Financial Strategy

(iii) an appropriate discount rate to be used in the evaluation of this project
(iv) the NPV of the project using the discount rate calculated in (iii); and
comment briefly on your choice of discount rate in part (iii).

(11 marks)

(b) Evaluate the benefits and limitations of using a proxy company’s beta to determine
the rate to be used by REM in the circumstances here, and recommend alternative
methods of adjusting for risk in the evaluation that could be considered by the

(9 marks)

(c) Advise the Managing Director on the benefits of a post-completion audit. A report for-
mat is not required in answering this question.

(5 marks)
25 marks)

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