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Paper F9
Financial Management
Progress Test 2
Question Paper

Interactive World Wide Ltd, February 2015

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Question 2

Sagitta plc is a manufacturer of navigation equipment for the aviation industry. The
company is currently considering whether or not to establish a new manufacturing division
which will produce passenger safety equipment for ships. The following information is
available to help evaluate the viability of the new product:


Costs incurred in designing and developing the new product, which have all
been paid, were $220,000. These costs are to be written off in equal instalments
against profits generated over the new products expected life of four years.
Sales are expected to be 18,000 units per year over the next four years. The
selling price of each unit will be $40 in the first three years and 30 in the final
Variable costs are estimated to be $15 for each unit.
Additional fixed costs are expected to be $295,000 per year. This includes a
charge for depreciation of equipment used in the manufacture of the product of
$80,000 per year.
Equipment that originally cost $800,000 and which has a written down value of
$450,000 will be used to produce the new product. If the new product is not
manufactured, the equipment will be sold immediately for $420,000 as it cannot
be used for any other purpose. If, however, the product is manufactured, the
equipment will be sold at the end of four years for $86,000.
Additional working capital of $120,000 will be required immediately to support
the manufacture of the new product. This will be released at the end of the life
of the new product.

The following information has been taken from the statement of financial position of the
company for the year that has just ended:
Share capital and reserves
$1 ordinary shares
Retained profits


Loan capital
6% loan stock
Bank loan


The ordinary shares have a current market value of $535 per share and the equity beta
of the company is 12. The returns to the market are 104% and the risk-free rate is 51%.
The loan stock is irredeemable and currently trading at $110 per $100 nominal value. It
can be assumed that all of the companys loan capital is risk free. The company will not
need to raise new finance for the new venture.
The Finance Department has identified a company which manufactures passenger safety
equipment for ships. The company is financed 50% by equity and 50% by loan capital,
based on market values, and has an equity beta of 16. The effective corporation tax rate
is 25% and tax is payable in the year in which the taxable profit occur. Ignore inflation
and capital allowances (tax allowable depreciation).

(a) Identify and discuss three key assumptions that underpin the use of the
weighted average cost of capital as an appropriate discount rate for
investment appraisal purposes.
(6 marks)
(b)Explain and calculate the weighted average cost of capital that should be
used as the discount rate when evaluating the new proposal.
(6 marks)
(c) Calculate the net present value of the project and comment on whether
this project is financially acceptable to Sagitta plc.
(7 marks)
(d)Distinguish between risk and uncertainty and discuss how sensitivity
analysis and probability analysis can be used to incorporate risk into the
investment appraisal process.
(6 marks)
(25 marks)