Ian Co is a profitable company which is financed by equity with a market value of $180 million and by debt with a market value of $45 million. The company is considering two investment projects, as follows.

Market Value

Equity = $180

Debt = $ 45

Project A

This project is an expansion of existing business costing $35 million, payable at the start of the project, which will increase annual sales by 750,000 units. Information on unit selling price and costs is as follows:

Selling price: $2.00 per unit (current price terms)

Selling costs: $0.04 per unit (current price terms)

Variable costs: $0.80 per unit (current price terms)

Selling price inflation and selling cost inflation are expected to be 5% per year and variable cost inflation is expected to be 4% per year. Additional initial investment in working capital of $250,000 will also be needed and this is expected to increase in line with general inflation.

Project B

This project is a diversification into a new business area that will cost $4 million. A company that already operates in the new business area, GZ Co, has an equity beta of 1.5. GZ Co is financed 75% by equity with a market value of $90 million and 25% by debt with a market value of $30 million.

Other information

Ian Co has a nominal weighted average after-tax cost of capital of 10% and pays profit tax one year in arrears at an annual rate of 30%.The company can claim capital allowances(tax-allowable depreciation)on a 25% reducing balance basis on the initial investment in both projects.

Risk-free rate of return: 4%

Equity risk premium: 6%

General rate of inflation: 4.5% per year

Directors views on investment appraisal

The directors of Ian Co require that all investment projects should be evaluated using either payback period or return on capital employed(accounting rate of return). The target payback period of the company is two years and the target return on capital employed is 20%, which is the current return on capital employed of Ian Co. A project is accepted if it satisfies either of these investment criteria. The directors also require all investment projects to be evaluated over a four-year planning period, ignoring any scrap value or working capital recovery, with a balancing allowance(if any)being claimed at the end of the fourth year of operation.

Required:

(a)Calculate the net present value of Project A and advise on its acceptability if the project were to be appraised using this method.

(b)Critically discuss the directors' views on investment appraisal.

(c)Calculate a project-specific cost of equity for Project B and explain the stages of your calculation.

Solution.

Cost

Project A Expansion3.5

Project B Diversification 4

Total costs 7.5

Depreciation on reducing balance basis.

Amount

Capital Allowance Accumulated Capital Allowance

Year 17.5 (25%) 1.8751.875

Year 25.625 (25%) 1.406253.281

Year 34.2188(25%)1.0554.336

Year 43.1638(25%)0.79105.127

Depreciation

YearCapital Allowance Tax Depreciation

Year 0

Year 11.8750.31.575

Year 21.406250.31.1063

Year 31.0550.30.755

Year 40.79100.30.491

Sales Revenue S.P/unit

Year 0 (current) = 2.00

Year 1 2.00 (1.05) = 2.1

Year 2 2.1 (1.05) = 2.205

Year 3 2.205 (1.05) = 2.31525

Year 4 2.31525 (1.05) = 2.4310

Sales Costs inflation 5%

Inflation factorS.cost/unit

Year 0 0.04

Year 1 0.04 (1.05) 0.042

Year 2 0.042(1.05)0.0441

Year 3 0.0441(1.05)0.0463

Year 4 0.0463(1.05)0.0486

Variable costs 4%

Inflation factor V.cost/unit

Year 00.08

Year 1 0.08 (1.04) 0.0832

Year 2 0.0832(1.04)0.0865

Year 3 0.0865(1.04)0.09

Year 4 0.09(1.04)0.0936

Working Capital

Inflation factor Working Capital

Year 0 250

Year 1 250(1.045) 261.25

Year 2 261.25(1.045)273.01

Year 3 273.01(1.045)285.29

Year 4 285.29(1.045)298.13

Discounted Cashflow AnalaysisYear 0 Year 1Year 2Year 3 Year 4

Sales revenue 2 2.12.2052.315252.4310

Less costs:

Selling costs(0.04)(0.042)(0.0441)(0.0463) (0.0486)

Variable costs(0.08)(0.0832)(0.0865)(0.09) (0.0936)

EBIT1.881.97482.07442.17902.2888

Less

Tax (30%) (0.564)(0.5924)(0.6223)(0.6537)(0.6866)

EAT 0.39480.41470.43560.45760.4806

Add Depreciation 1.5751.10630.7550.491

Total 0.39481.98971.54191.21260.9716

Units 750 750 750 750 750

Total 296.11,492.275 1,156.425909.45728.7

Less

Net investment

W.C (250) (261.25)(273.01) (285.29)(298.13)

Free Flow Cashflow46.11,231.025883.415 624.16430.5

Discounting

NPV = PV I.O

PV = Cashflow(1+r)n 000'

YearCashflowWACC(10%) Discounting FactorPresent Value

0(3,500)1.101(3,500)

11,231.0251.111.11,119.114

2883.4151.121.21730.095

3624.161.131.331468.941

4430.51.141.4641294.037

Total PV2,612.187

NPV (PV-I.O)- 887.813

Decision Criteria based on the NPV

The NPV is negative. Since the NPV is negative, (-887.813) indicating that the expected returns from the project will be negative, the directors of the company should reject the project and hence they should not undertake the expansion of the existing business.

Question b)

Critically discuss on the directors' view on investment appraisal

The directors of the company require that all investment projects should be evaluated using either payback period of the company or return on capital employed (accounting rate of return). The target payback period of the company is 2 years and the target return on capital employed is 20% which is the current return on capital employed of Ian Co. A project is accepted if it satisfies either these investment criteria.

i. Payback period

It is defined as the length of time taken by the project to recoup the initial cash outlay. The amount in which the expected cash inflows generated from investment projects will cover the initial cost of the project varies from one project to another. Setting the required payback period is subjective and hence it is upon the management to determine their preferred payback period given the nature of their company. The decision rule depends on the firms target payback period (i.e the maximum period beyond which the project should not be accepted.)

It is given by:

For even cashflows:

Payback period = I.O(Initial cash Outflows)

Annual cashflowsFor uneven cashflows:

Payback period = A + B/C

where:

A last period of with negative cumulative cashflowB- Absolute value of cumulative cashflow at the end of the period A

C- Total cash flow during the period after A

The decision criteria is to accept the project with a shorter payback period is preferred. The shorter the payback period, the less risky is the investment. For this reason, the payback period can be said to be risk-related criterion that requires to be met before funds are actually spent.

Decision Criteria for Project A based on Payback period

Since project A generates a negative NPV (Net present value) over the four year period, it will be rejected by the management of the company since it is not able to generate income that will recoup the initial investment cost of 3.5Million.

Merits of using Payback period in Project Appraisal

It is simple to compute

It can be used in assessing the inherent risk in a project. This is because cashflows arising after the payback period is considered uncertain and hence the payback period is a good measure of how certain the project cash inflows are.

Liquidity Problems

It is an ideal method for use by companies with liquidity problems since it helps the companies to rank projects according to the ones that are able to generate returns on money invested in the shortest period possible.

Demerits of using Payback period in project Appraisal

i. Time value of money

The major setback for using this criteria is that it ignores any benefits that occur after the payback period and is therefore not an indicator of the profitability of the enterprise. It also ignores the time value of money. This implies that this method of project appraisal is not very reliable and could lead to the company making wrong decisions. Hence the only way to eliminate this setback is by using discounted payback period method.

ii. Extra cashflowsIt also does not consider the return on investments that arise after the payback period.

Single asset orientation

The payback formula does not account for the output generated by the entire system but only a specific operation. Hence its use is more applicable to the tactical level rather than the strategic level

Incorrect mean

The denominator of the formula is based on the average cash flows from the project over several years. However, in case the forecasted cashflows are in mostly in the part of the forecast furthest in the future, the computations yield to a payback that is too soon.

Overall view

Essentially, payback period is more useful in industries where investments obsolete very quickly and where return on the initial investment is of great importance. The payback method should therefore not be used as the sole criterion for approval of a capital investment. Instead other project appraisal techniques that put into account the time value of money should be considered too. Nevertheless, the throughput analysis should be used in order to see if the investment will actually boost the performance and the corporate profitability. Other considerations that should be given preference when making capital investment decisions include whether the investment should be purchased in volume to reduce maintenance cost or whether lower-cost and lower capacity units would make more sense than and expensive asset.

ii. Accounting rate of return

The accounting rate of return divides the average profit by the initial investment in computing the expected return. It is a non-discounted cashflow method and does not consider the time value of money. The implication of this is that the returns taken during the later years may be worth less than those taken now. Nevertheless, it does not consider the cashflows which is an integral part of maintaining the enterprise. Accounting rate of return is considered to be straight-line method of gathering quantitative information.

It is computed as follows:

ARR = Average Annual income

Average investment

Where average annual income = average cashflows Average depreciation

Average investment = (cost of investment salvage value)

Hence for the ARR for project A will be given by:

ARR = Average Annual income

Average investment

ARR = Average Annual income = 5715.8

4

Average annual income = 1,428.95

Average investment = 3,500

2

Average investment = 1,750

ARR = 1,428.95

1,750

ARR = 0.8165 ~ 81.65%

Decision criteria

Since the ARR generated by the project is higher than the set return on capital employed of 20%, the project A should be undertaken.

The decision criteria is that in the case of mutually exclusive projects, the one with higher ARR are preferred. If the ARR is equal to or greater than the required accounting rate of return, the project should be accepted.

Advantages of ARR

It is quite simple to compute the formula

It takes into consideration the profitability factor in investment

Demerits of using ARR

Time value of money.

This method ignores time value of money. It may be confusing computing the accounting rate of return for projects with the same initial investment as the project with the higher annual income in the latter years of its useful life may rank higher than the one having a higher annual income in the beginning years.

Consistency.

This method lacks consistency since it can be computed in different ways.

Cashflow information.

It uses the accounting income rather than the cash flow information. Hence, it is not suitable for projects having high maintenance costs since their viability depends upon timely cash inflows. Nevertheless, this measure includes all non-expenses and does not reveal the return on actual cash inflows.

Question c)

Computation of project specific cost of equi...

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