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CORPORATE FINANCE (UKFF 3013)

JANUARY 2019 TRIMESTER


TUTORIAL 9 (WEEK STARTING 18 MARCH 2019
INVESTMENT APPRAISAL: APPLICATIONS AND RISK (CHAPTER 7)

QUESTION 1

CVB is considering whether to invest in new equipment costing RM600,000.


The equipment is expected to have an economic life of five years and will have
no disposal value at the end of Year 5 (and no disposal costs).

CVB’s after-tax cost of capital is 15%. Tax is charged at an annual rate of 35%
and is payable in the year following the year in which the taxable profits arise.

The following forecasts relate to the project under consideration:


RM’000
Year 1 2 3 4 5
Sales income 250 250 300 350 400
Direct materials 50 55 58 60 70
Direct labour 25 25 30 30 35
Total direct costs 75 75 88 94 105
Depreciation 120 120 120 120 120

There will be tax allowances on the cost of the equipment, calculated at 25%
each year on a reducing balance basis. The first depreciation tax allowance
(capital allowance) would be claimed in Year 0 (or very early in Year 1).

Assume that:
1. Taxable profits are defined as income minus direct costs and capital
allowance,
2. Cash profits in each year = sales minus direct costs

Required:
Calculate the Net Present Value of the project and recommend whether or not
the project should be undertaken.

SUGGESTED ANSWER.

Tax allowances on the investment

Year of Tax savings Cash flow year


claim (35%)
0 600,000 x 0.25 150,000 52,500 1
1 150,000 x 0.75 112,500 39,375 2
2 112,500 x 0.75 84,375 29,531 3
3 84,375 x 0.75
63,281 22,148 4
4 63281 x 0.75 47,461 16,611 5

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CORPORATE FINANCE (UKFF 3013)
JANUARY 2019 TRIMESTER
TUTORIAL 9 (WEEK STARTING 18 MARCH 2019
INVESTMENT APPRAISAL: APPLICATIONS AND RISK (CHAPTER 7)

5 Balancing 142,383 49,834 6


Allowance

600,000 - 0 600,000 209,999

Note: It is assumed that the company has taxable profits against which it claim
an allowance in Year 0 (or early Year 1)
Year 0 1 2 3 4 5 6

RM’000 RM’000 RM’000 RM’000 RM’000 RM’000 RM’000


Sales 250 250 300 350 400
Materials (50) (55) (58) (64) (70)
Labour (25) (25) (30) (30) (35)
Cash 175 170 212 256 295
profits
Tax @ (61) (60) (74) (90) (103)
35%
Capital (600)
equipment
Cash 53 39 30 22 17 50
effect of
allowance
Net cash (600) 228 148 182 204 222 (53)
flow
Discount 1.000 0.870 0.756 0.658 0.572 0.497 0.432
factor @
15%
Present (600 198 112 120 117 110 (23)
value
NPV 34
Comment The project is just worthwhile because the NPV is + 34,000.
However, the NPV is quite small in relation to the size of the
capital investment and in view of the fact that it is a five-year
project.

It might be appropriate to carry out some risk and uncertainty


analysis on the project before deciding whether or not to
undertake it.

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CORPORATE FINANCE (UKFF 3013)
JANUARY 2019 TRIMESTER
TUTORIAL 9 (WEEK STARTING 18 MARCH 2019
INVESTMENT APPRAISAL: APPLICATIONS AND RISK (CHAPTER 7)

QUESTION 2

Consolidated Oil wants to explore for oil near the coast of Singapore. The
Singaporean government is prepared to grant an exploration license for a five-
year period for a fee of S$ 300,000 per year. The option to buy the license
must be taken immediately; otherwise another oil company will be granted the
license.

However if it does take the license now, Consolidated Oil will not start its
exploration until the beginning of the second year.

To carry out the exploration work, the company will have to buy equipment now.
This would cost S$10,400,000 with 50% payable immediately and the other
50% Payable one year later. The company hired a specialist firm to carry out
a geological survey of the area. The survey cost S$250,000 and is now due for
payment.

The company’s financial accountant has prepared the following project income
statements. The forecast covers years 2- 5 when the oilfield would be
operational

Projected income statement

2 3 4 5
S$’000 S$’000 S$’000 S$’000 S$’000 S$’000 S$’000 S$’000
Sales 7,400 8,300 9,800 5,800
Minus
expenses:
Wages & 550 580 620 520
salaries
Materials & 340 360 410 370
consumables
License fee 600 300 300 300
Overheads 220 220 220 220
Depreciation 2,100 2,100 2,100 2,100
Survey cost 250 - - -
written off

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CORPORATE FINANCE (UKFF 3013)
JANUARY 2019 TRIMESTER
TUTORIAL 9 (WEEK STARTING 18 MARCH 2019
INVESTMENT APPRAISAL: APPLICATIONS AND RISK (CHAPTER 7)

Interest 650 (4,710) 650 (4,210) 650 (4,300) 650 (4,160)


charges
2,690 4,090 5,500 1,640

Notes
(i) The license fee charge in Year 2 includes the payment that would be
made at the beginning of year 1 as well as the payment at the beginning
of Year 2. The license fee is paid to the Singaporean government at the
beginning of each year.
(ii) The overheads include an annual charge of S$120,000 which represents
an apportionment of head office costs. The remainder of the overheads
are directly attributable to the project.
(iii) The survey cost is for the survey that has been carried out by the firm of
specialists.
(iv) The new equipment cost S$10,400,000 will b sold at the end of Year 5 or
s$2,000,000.
(v) A specialize item of equipment will be needed for the project for a brief
period at the end of year 2. This equipment is currently used by the
company in another long-term project. The manager of the other project
has estimated that he will have to hire machinery at a cost of S$150,000
for the period the cutting tool is on loan.
(vi) The project will require an investment of S$650,000 working capital from
the end of the first year to the end of the license period.

The company has a cost of capital of 10%. Ignore taxation.

Required:
Calculate the NPV of the project.

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CORPORATE FINANCE (UKFF 3013)
JANUARY 2019 TRIMESTER
TUTORIAL 9 (WEEK STARTING 18 MARCH 2019
INVESTMENT APPRAISAL: APPLICATIONS AND RISK (CHAPTER 7)

SUGGESTED ANSWER

Year 0 1 2 3 4 5
$’000 $’000 $’000 $’000 $’000 $’000
Sales 7,400 8,300 9,800 5,800
Wages (550) (580) (620) (520)
Materials (340) (360) (410) (370)
License fee (300) (300) (300) (300) (300)
Overheads (100) (100) (100) (100)
Equipment (5,200) (5,200) 2,000
Specialized (150)
equipment
Working (650) 650
capital
Net cash (5,200) (6,150) 5,960 6,960 8,370 7,160
flow
Discount 1.000 0.909 0.826 0.751 0.683 0.621
factor
Present (5,200) (5,590) 4,923 5,227 5,717 4,446
value
NPV 9,523,0000

QUESTION 3

SC Co is evaluating the purchase of a new machine to produce product P,


which has a short product life-cycle due to rapidly changing technology. The
machine is expected to cost $1 million. Production and sales of product P are
forecast to be as follows:

Year 1 2 3 4
Production and sales (units/year) 35,000 53,000 75,000 36,000

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CORPORATE FINANCE (UKFF 3013)
JANUARY 2019 TRIMESTER
TUTORIAL 9 (WEEK STARTING 18 MARCH 2019
INVESTMENT APPRAISAL: APPLICATIONS AND RISK (CHAPTER 7)

The selling price of product P (in current price terms) will be $20 per unit, while
the variable cost of the product (in current price terms) will be $12 per unit.
Selling price inflation is expected to be 4% per year and variable cost inflation
is expected to be 5% per year. No increase in existing fixed costs is expected
since SC Co has spare capacity in both space and labour terms.
Producing and selling product P will call for increased investment in working
capital. Analysis of historical levels of working capital within SC Co indicates
that at the start of each year, investment in working capital for product P will
need to be 7% of sales revenue for that year.
SC Co pays tax of 30% per year in the year in which the taxable profit occurs.
Liability to tax is reduced by capital allowances on machinery (tax-allowable
depreciation), which SC Co can claim on a straight-line basis over the four-year
life of the proposed investment. The new machine is expected to have no scrap
value at the end of the four-year period.
SC Co uses a nominal (money terms) after-tax cost of capital of 12% for
investment appraisal purposes.

Required:
(a) Calculate the net present value of the proposed investment in product
P.

Workings
Sales revenue
Year 1 2 3 4
Selling price ($/unit) 20.80 21.63 22.50 23.40
Sales volume 35000 53000 75000 36000
Sales revenue 728000 1146390 1687500 842400

Variable costs
Year 1 2 3 4
Variable cost 12.60 13.23 13.89 14.58
($/unit)
Sales volume 35000 53000 75000 36000
Variable costs 441,000 701,190 1,041,750 524,880

Total investment in working capital


Year 0 investment 728,000 x 0.07 50,960
Year 1 investment 1,146,390 x 0.07 80,247
Year 2 investment 1,687,500 x 0.07 118,125

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CORPORATE FINANCE (UKFF 3013)
JANUARY 2019 TRIMESTER
TUTORIAL 9 (WEEK STARTING 18 MARCH 2019
INVESTMENT APPRAISAL: APPLICATIONS AND RISK (CHAPTER 7)

Year 3 investment 842,400 x 0.07 58,968

Incremental investment in working capital


Year 0 investment 728,000 x 0.07 (50,960)
Year 1 investment 80,247 – 50,960 (29,287)
Year 2 investment 118,125 – 80,247 (37,878)
Year 3 recovery 58,968 – 118,125 +59,157
Tear 4 recovery +58,968

Calculation of net present value


0 1 2 3 4
Sales 728,000 1,146,39 1,687500 842,400
revenue 0
Variable (441,000 (701,190) (1,041,750 (524,880
costs ) ) )
Contributio 287,000 445,200 645,750 31,7520
n
Capital (250,000 (250,000) (250,000) (250,000
allowances ) )
Taxable 37,000 195,200 395,750 67,520
profit
Taxation (11,100) (58,560) (118,725) (20,256)
After-tax 2,590 136,640 277,025 47,264
profit
Capital 250,000 250,000 250,000 250,000
allowances
After-tax 275,900 386640 527025 297264
cash flows

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CORPORATE FINANCE (UKFF 3013)
JANUARY 2019 TRIMESTER
TUTORIAL 9 (WEEK STARTING 18 MARCH 2019
INVESTMENT APPRAISAL: APPLICATIONS AND RISK (CHAPTER 7)

Initial (1,000,000
investment )
Working (50,960) (29,287) (37,878) 59,157 58,968
capital
Net cash (1,050,960 246,613 348,762 586,182 356,232
flows )
Discount @ 1.000 0.893 0.797 0.712 0.636
12
Present 1,050960 220,225 277,963 417,362 226,564
values
NPV 91,154

QUESTION 4
SCOT PLC
YEAR 0 1 2 3 4 5
(‘000) (‘000) (‘000) (‘000) (‘000) (‘000)

Operating profit 250 450 550 650 800

Interest (15) (15) (15) (15) (15)

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CORPORATE FINANCE (UKFF 3013)
JANUARY 2019 TRIMESTER
TUTORIAL 9 (WEEK STARTING 18 MARCH 2019
INVESTMENT APPRAISAL: APPLICATIONS AND RISK (CHAPTER 7)

Total 235 435 535 635 785

Taxation (47) (87) (107) (127) (157)

Total 188 (348) 428 508 628

Capital invested (600)

Working capital (250) No


recovery
,sold as
going
concern

Loan 250 (250)

After tax cash flows (600) 188 348 428 508 378

Exchange rate 3 4 5 6 7 8

Payable to UK (200) 47 69.6 71.3 72.6 47.25

UK tax 30% (5.9) (8.7) (8.9) (9.1) (9.8)

After tax cash flows (200) 41.1 60.9 62.4 63.5 37.44

Discount @ 20 % 1.000 0.833 0.694 0.579 0.482 0.402

Present values (200) 34.2 42.3 36.1 30.6 15.05

Net Present Value (41.75)

Conclusion Since the NPV is negative, the project is not acceptable on


financial grounds.

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