PR AC T ICE Q UE S T ION S – SE C T ION A : S EC TI ON 1

Required:
(a) Evaluate and comment on the performance of Vadener plc and each of its divisions.
Highlight performance that appears favourable, and any areas of potential concern
for the managers of Vadener. Comment upon the likely validity of the company’s
strategy to devote resources equally to the operating divisions.
All relevant calculations must be shown. Approximately 19 marks are available for
calculations, and 9 for discussion. (28 marks)
Professional marks for format, structure and presentation of the report for part (a).
(4 marks)
(b) Discuss what additional information would be useful in order to more accurately
assess the performance of Vadener plc and its divisions. (7 marks)
(c) Discuss the possible implications for Vadener plc of the £10 million loss on
translation, and recommend what action, if any, the company should take as a
result of this loss. (7 marks)
(d) The company has been advised that it can increase income by writing (selling)
options. Discuss whether or not this is correct, and provide a reasoned
recommendation as to whether or not Vadener plc should adopt this strategy.
(4 marks)
(Total: 50 marks)

ADVANCED INVESTMENT APPRAISAL

2 AVTO (DEC 03 ADAPTED)
Avto plc, a UK-based firm, is considering an investment in Terrania, a country with a
population of 60 million that has experienced 12 changes of government in the last
10 years. The investment would cost 580 million Terranian francs for machinery and other
equipment, and an additional 170 million francs would be necessary for working capital.
Terrania has a well-trained, skilled labour force and good communications infrastructure,
but has suffered from a major disease in its main crop, the banana, and the effect of
cheaper labour in neighbouring countries.
Terrania is heavily indebted to the IMF and the international banking system, and it is
rumoured that the IMF is unwilling to offer further assistance to the Terranian government.
The Terranian government has imposed temporary restrictions on the remittance of funds
from Terrania on three occasions during the last ten years.
The proposed investment would be in the production of recordable DVD players, which are
currently manufactured in the UK, mainly for the European Union market. If the Terranian
investment project was undertaken the existing UK factory would either be closed down or
downsized. Avto plc hopes to become more competitive by shifting production from the
UK.

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Additional information:
(i) UK corporate tax is at the rate of 30% per year, and Terranian corporate tax at the
rate of 20% per year, both payable in the year that the tax charge arises. Tax
allowable depreciation in Terrania is 25% per year on a reducing balance basis. A
bilateral tax treaty exists between Terrania and the UK.
(ii) The after-tax realisable value of the machinery and other equipment after four years
is estimated to be 150 million Terranian francs.
(iii) £140,000 has recently been spent on a feasibility study into the logistics of the
proposed Terranian investment. The study reported favourably on this issue.
(iv) The Terranian government has offered to allow Avto plc to use an existing factory
rent free for a period of four years on condition that Avto employs at least 300 local
workers. Avto has estimated that the investment would need 250 local workers.
Rental of the factory would normally cost 75 million Terranian francs per year before
tax.
(v) Almost all sales from Terranian production will be to the European Union priced in
Euros.
(vi) Production and sales are expected to be 50,000 units per year. The expected year 1
selling price is 480 Euros per unit.
(vii) Unit costs throughout year 1 are expected to be:
Labour: 3,800 Terranian (T) francs based upon using 250
workers
Local components: 1,800 T francs
Component from Germany: 30 Euros
Sales and distribution: 400 T francs
(viii) Fixed costs in year 1 are 50 million T francs.
(ix) Local costs and the cost of the German component are expected to increase each
year in line with Terranian and EU inflation respectively. Due to competition, the
selling price (in Euros) is expected to remain constant for at least four years.
(x) All net cash flows arising from the proposed investment in Terrania would be
remitted at the end of each year back to the UK.
(xi) If the UK factory is closed, Avto will face tax-allowable redundancy and other closure
costs of £35 million. Approximately £20 million after tax is expected to be raised from
the disposal of land and buildings.
(xii) If Avto decides to downsize rather than close its UK operations then tax-allowable
closure costs will amount to £20 million, and after-tax asset sales to £10 million. Pre-
tax net cash flows from the downsized operation are expected to be £4 million per
year, at current values. Manufacturing capacity in Terrania would not be large
enough to supply the market previously supplied from the UK if downsizing does not
occur.
(xiii) The estimated beta of the Terranian investment is 1.5 and of the existing UK
investment is 1.1.
(xiv) The relevant risk-free rate is 4.5% and market return 11.5%.
(xv) Money market investment in Terrania is available to Avto, paying a rate of interest
equivalent to the Terranian inflation rate.

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 PR AC T ICE Q UE S T ION S – SE C T ION A : S EC TI ON 1

(xvi) Forecast % inflation levels:

UK and the EU Terrania
Year 1 2% 20%
Year 2 3% 15%
Year 3 3% 10%
Year 4 3% 10%
Year 5 3% 10%
(xvii) Spot exchange rates:
Terranian francs/£1 36.85
Terranian francs/Euros 23.32

Required:
(a) Prepare a report that:
(i) Evaluates the financial acceptability of Avto plc investing in Terrania and
closing or downsizing its UK factory. State clearly all assumptions that you
make. (22 marks)
(ii) Discusses the wider commercial issues that the company should consider, in
addition to the financial appraisal, before making its decision on whether to
invest. (8 marks)
Professional marks will be awarded in part (a) for the format, structure and
presentation of the report. (4 marks)
(b) Estimate the possible impact of blocked remittances in Terrania for the planning
horizon of four years, and discuss how Avto might react to blocked remittances.
(10 marks)
(c) The directors of Avto plc are considering issuing some £100 nominal value ten year
bonds at an issue price of £90 (to make them look attractive to potential investors).
Based on Avto plc’s credit rating, investors are expected to require a return of 7% per
year from such bonds.

Required:
Calculate the coupon rate that Avto plc will have to pay on these bonds in order to
satisfy the investors. (6 marks)
(Total: 50 marks)

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