SECTION A – THIS QUESTION IS COMPULSORY, AND MUST BE ATTEMPTED

Question 1
Happy Farmer Co (HP Co) is a listed company involved in the manufacture of innovative and eco-friendly agricultural
machinery. Their products are priced reasonably, which makes them highly attractive for the farming industry. HP Co’s
mission statement reflects this spirit of innovation, and it also states that the company aims to behave in an ethical
manner with regards to its stakeholders. This has resulted in HP Co earning a strong reputation, and it also has a
relatively higher share price than its competitors in its industry.
HP Co is planning to undertake a new project, involving the manufacture and sale of a portable harvesting machine.
This project is called the Porthav project. The Porthav will be priced lower than competitors’ offerings, and it has the
added advantage of being 80% recyclable. This is a new business area for HP Co, and this project is expected to last
for 4 years. The portable harvester will allow small farmers to work quickly within confined spaces. The drones will
enable farmers to increase crop yields and reduce crop damage.
HP Co will also work on the Nexthav Project (a follow-on project to the Porthav Project) to make 98%+ recyclable
harvesters. HP Co expects that the Nexthav Project will last for a further five years after the Porthav Project has finished.
If the Porthav Project is discontinued or sold sooner than four years, the Nexthav Project could still be undertaken after
four years.

Porthav Project
The production and sales demand of harvesters are expected to be:
Year 1 2 3 4
Number of harvesters produced and sold 4,000 20,000 35,000 24,000

The expected selling price and variable cost per unit in the first year for each harvester is $1,200 and $500 respectively.
Project specific fixed cost in the first year is expected to be $3,000,000. Selling price is expected to increase by 8% per
year, after the first year. Variable cost and fixed cost will increase after the first year by 4% and 10% respectively, after
the first year. There is also training costs expected to be incurred as a percentage of variable cost. This is expected to
be 200% in the first year, followed by 70% in year 2, and 10% in year 3 and 4. The finance director believes that there
is substantial uncertainty over the cash flows of the project, expected to be at a standard deviation of 30%.

Working capital required for the project is expected to be 20% of sales revenue at the start of the project. In every
subsequent year, the investment in working capital is expected to be 10% for every $1 increase or decrease in sales
revenue. All investment in working capital is expected to be recovered in full at the end of the project life.

The Porthav Project requires an initial investment in machinery of $40,000,000. The cost of machinery is eligible for tax
allowable depreciation (TAD) of 20% per year on a straight-line basis. At the end of the project life, the machinery can
be sold for a post-inflation price of $6,000,000. It can be assumed that HP Co has sufficient profits at the group level to
absorb any tax losses, should they arise, on the project. Tax is paid in the year that it is incurred.

Nexthav Project as a real option

HP Co estimates that the Nexthav Project’s cash flows are highly uncertain. It is estimated that the project cash flows
will have a standard deviation of 50%. The initial investment required at the start of the project in 4 years’ time is
expected to be $60,000,000. HP Co has estimated the initial NPV of the project, at the start of the project, to be
$8,000,000.

The following figures were estimated for the Nexthav Project using the real options method.

Asset value (Pa) = $44,800,000 (to nearest $100,000)

Exercise price (Pe) = $60,000,000
Exercise date (t) = 4 years
Risk-free rate (r) = 2·00%
Volatility (s) = 50%

d1 = 0·2879 d2 = –0·7121 N(d1) = 0·6133 N(d2) = 0·2382

Call option value: $14,282,661

The call option value can be assumed to be estimated accurately.

HP Co’s finance director isn’t certain as to how the asset value (Pa) of $44,800,000 was determined. He wants an
explanation to clarify his doubts.

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Big Farmer Co’s (BF Co) offer
BF Co is a company operating in a neighbouring country to HP Co. It also manufactures and sells harvesters. It has
approached HP Co to buy the Porthav project entirely for a price of $28,000,000, at the beginning of the third year of
the project’s life.

The Finance Manager of HP Co has calculated some input figures to assess the value of BF Co’s offer, using the real
options valuation model, as follows:
d1 = 0·7385 d2 = 0·3142 N(d1) = 0·7699 N(d2) = 0·6233

HP Co’s finance director has asked the finance manager to estimate the value of BF Co’s offer by using the real options
method.
He wants to know what the initial variables were, that was used to estimate the d1, d2, N(d1) and N(d2) figures. You may
assume that the d1, d2, N(d1) and N(d2) figures given above have been accurately estimated.

Additional information
Both HP Co and BF Co pay corporation tax at an annual rate of 20%. HP Co has estimated Porthav Project’s and
Nexthav Project’s risk-adjusted cost of capital at 11%, based on BF Co’s asset beta. The risk-free rate of interest is
expected to be 2%

Required:
(a) Provide a reasoned discussion on how the inclusion of real options into the NPV decisions can help
HP Co make better investment decisions.
(5 marks)
(b) Prepare a report for the board of directors (BoD) of HP Co which:
(i) Estimates the net present value of the Porthav Project before considering the offer from BF Co and
the Nexthav Project; (all relevant calculations must be shown)
(12 marks)
(ii) Provides an explanation of how the asset value of the Nexthav project was determined (as requested
by the Finance Director), and an estimate of the value of the BF Co offer using the real options method;
(9 marks)
(iii) Based on the analysis done in (b)(i) and (b)(ii) above, provide a reasoned assessment of whether the
Porthav project should be undertaken, with a discussion of the assumptions made in the calculations.
(10 marks)
Professional marks will be awarded in part (b) for the format, structure and presentation of the report.
(4 marks)
(c) The Board of HP Co recently attended a trade show, to showcase the eco-friendly features of the Porthav.
The Porthav attracted significant interest from large farming companies worldwide, including agricultural government
ministries. However, many government representatives commented that the price seemed high for a compact harvester
of this nature.
After the trade show, the Board of HP Co convened to discuss the concerns raised by prospective buyers concerning
the price of the Porthav. The Board realised that the only way to reduce prices and remain profitable was to shift the
manufacturing of the Porthav to another country, where lower cost resources can be obtained. HP Co decided that
shifting production to Freeland, an Asian country with low-cost labour and raw materials will be viable. HP Co already
buys components and parts from suppliers in Freeland, for its other products.
However, there has been recent political developments in Freeland that has raised concerns. The newly elected
government has been overthrown by a military coup, with violent action taken by the military to silence peaceful protests.
There have also been news reports suggesting the use of child labour by foreign companies operating factories in
Freeland. The companies identified as using child labour have commented that they supported the children by paying
for their education, and if they stopped employing them, the families can face severe financial difficulties.
Required:
Provide a discussion of the possible ethical and sustainability issues raised above and its impact on BF Co if
it decides to relocate to Freeland, and how the board my address these issues.
(10 marks)
(50 marks)

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SECTION B – ANSWER BOTH OF THE FOLLOWING QUESTIONS

Question 2

The board of directors of Lion Co have asked the Finance Director to come with a draft guidance manual in estimating
the cost of capital of the company, to be used in the evaluation of the NPV of projects. The Finance Director has
delegated this task to junior finance manager, with limited experience, to handle this task. The junior finance manager
has prepared a draft of the manual, where the extracts of the manual, with some illustrative examples are given below.

Draft Manual to guide the estimation of the cost of capital.

1) It is required that the cost of capital to be used as a discount rate must be the weighted average cost of capital
of the company.
2) The cost of equity and the cost of debt can be estimated using either book values or market values.
3) Once the cost of capital has been calculated, an allowance for the effect of inflation must then be added into
the estimated cost of capital.
4) The estimate of the cost of equity can be done using either the Capital Asset Pricing Model (CAPM) or the
Dividend Growth Model (DGM), and both approaches are acceptable
5) The cost of debt can be estimated using the gross redemption yield of existing debt.
6) The calculated cost of capital should always be rounded up to the nearest whole figure. This is done to ensure
that the cost of capital is never under-estimated.

Sample calculations provided by the junior Finance Manager:

It is January 2020 now, and the secured bonds issued by the company has four years to maturity.

Relevant data:
Book values Market values
Issued shares (50m ordinary shares) $140m $214m
Debt finance ($40m in bank loans, 10% secured bonds 2024 $40m) $80m $85m

Per share Annual growth rates

Dividends 24c 6%
Earnings 67c 9%

The company has an asset beta of 1.1.

Other relevant information:

Returns on the average stock market (All-Share index) 14%
Returns on short-dated government bonds 6%
Current inflation rate 4%
Tax rate for corporations 30%

Illustration 1 – The relevant cost of capital when the company is expanding its current activities

Cost of equity (ke)

D 24
Dividend valuation model: +g= + 0 . 09 = 0.146 or 14.6%
P 428
Capital pricing model:

ke = Rf + (Rm - Rf) beta = 6% + (14% - 6%) 1.1 = 14.8%

Cost of debt

The cost of debt will be taken as the redemption yield on existing bonds, assuming four years to maturity, by solving
the equation below.

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It is assumed that debt will be redeemed at par value, and it is assumed that the interest on the debt is paid annually.
The estimates below are based on total interest payments of $8m per year, which is $80m multiplied by 10%.

8 8 8 8
85 = + + +
(1 + kd ) (1 + kd )
2
(1 + kd )3
(1 + kd )4

By trial and error

At 9% interest 8  3.240 25.92
80  0.708 56.64
_____
82.56
_____
9% discount rate is too high.
At 7% interest 8  3.387 27.10
80  0.763 61.04
_____
88.14
` _____
Interpolating between both the above, the cost of debt should be:
3.14
7% +  2% = 8.13%
3.14 + 2 . 44
The cost of debt is 8.13%

Market value of equity £214m. Market value of debt £85m

Weighted average cost of capital

(The CAPM estimate has been used below. If the dividend valuation model is used, it will result in the same answer.)

214 85
14.8%  + 8.13%  = 12.90%
299 299
To get the inflation adjusted discount rate, the inflation rate of 4% is added to the above, to get (12.9% + 4%) = 16.9%.
Uses the rule in the guidance manual, this will be rounded up to 17% to ensure that the cost of capital isn’t under-
estimated.

Illustration 2 - When the company is diversifying its activities

A similar company has been identified, in the industry that the company is planning to diversify into. This proxy company
has an asset beta of 0.90. The asset beta of a similar sized company in the industry in which your company proposes
to diversify is 0.90.

The capital structure of the similar company in the industry is: Book values Market values

$m $m

Equity 165 230

Debt 65 60

Cost of equity
The asset beta of the proxy company is used as a basis to measure the systematic risk of the proposed new investment.
Given that the gearing of both companies is different, the beta factor must be adjusted for the differences in the gearing
level.
E
Degearing: Beta equity = beta asset 
E + D (1 − t )

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 230
Beta equity = 0.90  = 0.76
230 + 60 (1 − 3 )

Using the CAPM to find the cost of equity:

ke = Rf + (Rm - Rf) beta = 6% + (14% - 6%) 0.76 = 12.08%

Cost of debt
It is assumed that this remains at 8.13%.

The market value of equity and debt is $214m and $85m respectively.

The Weighted average cost of capital

214 85
12.08%  + 8.13%  = 10.96%
299 299
The inflation rate of 4% will be added to the above WACC estimate to arrive at a project specific cost of capital of
14.96%. This will then be rounded up to 15% to ensure that the cost of capital isn’t underestimated.

Required:
a) Prepare a revised guidance manual on the estimation of the cost of capital, highlighting the original
errors made in the draft manual. The amendments made to the original 6 guidance notes must be
clearly stated. State clearly any assumptions made
(12 marks)
b) Provide illustrative calculations, with corrections, to support the revised manual on the estimations
of the cost of capital. You should state the mistakes made, and the appropriate corrections. State
clearly any assumptions made.
(13 marks)
(Total 25 marks)

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 Question 3
ABC Co is a large listed company involved in the ship building industry. You have been appointed to the post of a senior
financial executive, reporting directly to the CFO. Your first task is the evaluation of a new investment project, namely the
building and operating of a large-scale oil tanker project. The project has been named the Oil Giant. This project can be
seen as an expansion of the existing activities of the firm.

The initial investment required to undertake the project is $800m. This outlay is expected to be made immediately. The
forecast revenues expected to be generated at the end of each of the following 5 years of the project life will be as follows:

Year 1 2 3 4 5
Revenue ($m) 680 900 900 750 320

The direct variable costs related to the project is expected to be 60% of the revenues. The board also wants to allocate
indirect activity-based costs, using the usual cost apportionment methods, of $100m per year for each of the 5-year life of
the project. These indirect costs are expected to increase at a rate of 4% per year, from the first year onwards. Given the
size of this project, the company expects to give up other work, to accommodate this project in their factory. The work given-
up is expected to generate a net contribution of $150m per year, in year 1 and 2 only, before taking into consideration
indirect cost allocation of $20m per year.
The capital expenditure of $800m will be paid immediately (Year 0). The company expects that the project will have a
residual value of $40m at the end of the five-year life of the project. The policy of the company is to depreciate all non-
current assets on a straight-line basis over the useful life of the asset. The company has undertaken an initial feasibility
study costing $40 million. This expense has been incurred and paid. The usual policy of the company is to charge such
feasibility study costs in the first year of the project, once the project is operational.

The company is subject to corporation tax on profits at a rate of 30%, with no delay on the payment of tax, or the receipt of
any tax credits or allowances. To encourage companies to undertake large scale investments, and create new job
opportunities in the process, the Inland Revenue allows companies to claim a first-year allowance of 50% on the initial
investment, followed by a tax allowable depreciation (TAD) of 40% on a reducing balance basis for the remainder of the
project life. A balancing allowance or a balancing charge can be claimed in the final year of the project life. You may assume
that the company has sufficient profits available from other projects to absorb any losses that may arise from undertaking
the Oil Giant project.

The shares of the company are traded in an international stock market. It has in issue 1,000 million shares, where the
current share price is $7.50 per share. The company secured bonds in issue, with a par value $2,000 million. These bonds
are trading at $125 per $100 nominal value. The yield on short-dated government bonds is 5%, and the companies cost of
debt (normal cost of borrowing) is expected to be 200 basis points above the risk-free rate. The equity beta of the company
is 1.40, and the equity risk premium is 3.5%.
The project will be financed entirely through a new bond issue, where the coupon will be the same as the current normal
borrowing cost of the company. These bonds will be redeemable in 5-years’ time at par value. The financial advisors to the
company believe that the bond issue will not alter the existing credit rating of the company. The issue costs of the new bond
issue are expected to be 2% of the gross proceeds from the bond issue. The issue costs will be funded from existing
reserves, and the issue costs are not eligible for tax relief.
Required:

(a) Evaluate the above project, using whatever method you think is feasible. You should provide a
justification of the method of evaluation used, together with appropriate calculations/workings, and a
reasoned conclusion on the acceptability of the project.
(15 marks)
(b) Using only the base case NPV cash flows, estimate the Modified Internal Rate of Return (MIRR) of the
project.
(5 marks)
(c) Estimate the impact on the project if it was funded entirely by a subsidised government loan, at an
interest rate of 100 basis points below the risk-free rate. There will not be any issue costs on the
subsidised loan.
(5 marks)
(Total 25 marks)

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