Charm Co, a software company, has developed a new game, “Fingo”, which it plans to launch in the near

future. Sales of the new game are expected to be very strong, following a favorable review by a popular
PC magazine. Charm has been informed that the review will give the game a “Best Buy” recommendation.
Sales volumes, production volumes and selling prices for “Fingo” over its four-year life are expected to be
as follows:

Year 1 2 3 4
Sales and production (units) 150,000 70,000 60,000 60,000
Selling price $25 $24 $23 $22
Financial information on “Fingo” for the first year of production is as follows:

Direct material cost $5.40 per unit

Other variable production cost $6.00 per unit
Fixed costs $4.00 per unit

Advertising costs to stimulate demand are expected to be $650,000 in the first year of production and
$100,000 in the second year of production. No advertising costs are expected in the third and fourth
years of production. Fixed costs represent incremental cash fixed production overheads. “Fingo” will be
produced using a new machine costing $800,000. Tax-allowable depreciation will be claimed on a
straight-line basis over four years. However, working capital equal to 8% of annual sales is required at
the start of each year.

Charm pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which they
arise. Charm uses an after-tax discount rate of 10% when appraising new capital investments.
Required:
(a) Calculate the net present value of the investment and comment on your findings. (10 marks)
(b) Calculate the internal rate of return of the investment and comment on your findings. (5 marks)
SC Co is evaluating the purchase of a new machine to produce product P. The machine is expected to
cost $1m. 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

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 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 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 pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced by tax-
allowable depreciation on machinery which SC 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 uses a nominal 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. (12 marks)
(b) Calculate the internal rate of return of the proposed investment in product P. (3 marks)
(15 marks)
Evaluation using either payback or return on capital employed

Both payback period and return on capital employed (ROCE) are inferior to discounted cash flow (DCF)
methods such as net present value (NPV) and internal rate of return (IRR). Payback ignores the time
value of money and cash flows outside of the payback period. ROCE uses profit instead of cash flow.
Both payback and ROCE have difficulty in justifying the target value used to determine acceptability.
Why, for example, use a maximum payback period of two years? DCF methods use the weighted
average cost of capital of an investing company as the basis of evaluation, or a project-specific cost of
capital, and both can be justified on academic grounds.

The company should also clarify why either method can be used, since they assess different aspects of
an investment project.

Regarding the directors’ policies on NPV calculations, the following comments can be made:

Evaluation over a four-year planning period

Using a planning period or a specified investment appraisal time horizon is a way of reducing the
uncertainty associated with investment appraisal, since this increases with project life. However, it is
important to determine the expected life of an investment project if at all possible, since evaluation over
the whole life of a project may help a company avoid sub-optimal investment decisions.

Inflation is ignored

If selling prices and costs have different inflation rates, the only way to accurately calculate NPV is to
forecast each cash flow in nominal terms (incorporating the specific inflation rate affecting that cash
flow) and discount the total nominal cash flow at the company’s nominal cost of capital (incorporating
the general inflation rate in the economy).

The only situation where ignoring inflation will lead to the correct NPV figure is when revenues and costs
all increase at the general inflation rate − in which case uninflated cash flows can be discounted at the
company’s real cost of capital.

Scrap value is ignored

Scrap value, salvage value or terminal value must be included in the evaluation of a project, even if the
planning period is shorter than the investment’s expected life. Ignoring scrap value would reduce the
NPV and may lead to rejection of an otherwise acceptable investment project.

A balancing allowance is claimed

Tax saving from a balancing allowance must be included in the evaluation of a project, even if the
planning period is shorter than the investment’s expected life. Ignoring this would reduce the NPV and
may lead to rejection of an otherwise acceptable investment project. Similarly, tax due on a balancing
charge must be included as to ignore it may lead to acceptance of a project that otherwise should be
rejected.

Working capital recovery is ignored

If an investment project ends, working capital can be recovered and must be included in the evaluation
of the project, even if the planning period is shorter than the investment’s expected life. The only
exception would be if the project will be repeated, in which case working capital would not be recovered
at the end of the initial evaluation period.
Question 1 of 3

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Question

CJ Co

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

Project A

This is an expansion of existing business costing $3.5m, 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. 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 is a diversification into a new business area that will cost $4m. 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 $90m and 25% by debt with a market value of $30m.

Other information

CJ 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 tax-allowable depreciation on a 25% reducing
balance basis. The directors require investment projects to be evaluated over a four-year planning
period, ignoring any scrap value or working capital recovery, with a balancing allowance being claimed
at the end of the fourth year of operation.

Risk-free rate of return 4%

Equity risk premium 6%

General rate of inflation 4.5% per year

Required:
 Calculate the net present value of Project A and advise on its acceptability if the
(a) project were to be appraised using this method. (10 marks)

Calculate a project-specific cost of equity for Project B and explain the stages of
(b) your calculation. (4 marks)

Discuss how the shareholders of a listed company can assess the extent to which
they face the following risks, explaining in each case the nature of the risk being
(c) assessed:

(i) Business risk;

(ii) Financial risk;

(iii) Systematic risk. (6 marks)

(20 marks)
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Question

Card Co

Card Co has in issue 8 million shares with an ex-dividend market value of $7.16 per share. A dividend of
$0.62 per share for 20X6 has just been paid. The pattern of recent dividends is as follows:

Year 20X3 20X4 20X5

Dividends per share $0.551 $0.579 $0.591

Card Co also has in issue 8.5% loan notes redeemable in five years’ time with a total nominal value of
$5m. The market value of each $100 loan note is $103.42. Redemption will be at nominal value.

Card Co is planning to invest a significant amount of money into a joint venture in a new business area.
It has identified a proxy company with a similar business risk to the joint venture. The proxy company
has an equity beta of 1.038 and is financed 75% by equity and 25% by debt, on a market value basis.
The current risk-free rate of return is 4% and the average equity risk premium is 5%. Card Co pays profit
tax at a rate of 30% per year and has an equity beta of 1.6.

Required:

(a) Calculate the cost of equity of Card Co using the dividend growth model. (3 marks)

Discuss whether the dividend growth model or the capital asset pricing model
(b) should be used to calculate the cost of equity. (4 marks)

Calculate the weighted average after-tax cost of capital of Card Co using a cost of
(c) equity of 12%. (4 marks)

Calculate a project-specific cost of equity for Card Co for the planned joint
(d) venture. (4 marks)

Discuss the factors to be considered in choosing between traded loan notes, new
(e) equity issued via a placing and venture capital as sources of finance. (5 marks)

(20 marks)