Progrow

Progrow plc is a company with 350 employees located in Southern England. The company has two
main products: a manually operated lifting jack for cars, and a range of high quality metal gardening
tools.

The company has some extra factory space which is currently surplus to the company’s needs and
may be use to expand its garden tool production. For a capital equipment expenditure of $200,000
the annual production of garden tools could be increased by 70,000 units per year.

As the company is located in a government approved development area, expenditure on any new
equipment would be eligible for tax allowable depreciation of 25% on reducing balance. This
equipment would have a scrap value of $40,000 after five years.

Expanding the production will call for increased investment in working capital. Analysis of historical
levels of working capital within Progrow indicates that at the start of each year, investment in working
capital will need to be 7% of sales revenue for that year.

The selling price of garden tool (in current price terms) $7.80 per unit, and the variable cost of the
product (in current cost terms) is $5.70 per unit. Selling price inflation is expected to be 5% per year
and variable cost inflation is expected to be 6% per year. No increase in existing fixed costs is expected
and incremental annual interest costs associated with the finance of the equipment are $10,000.

The company is listed on AIM (Alternative Investment Market), and its overall equity beta is 1.30. The
average equity beta of other Jack manufacturers is 2.31 with average gearing of 50% equity and 50%
debt. The financial gearing of Progrow is not expected to change with expansion of garden tool
production.

The appropriate risk free rate is 7% and the estimated market return 14%. Corporate taxation is at
the rate of 30% and is payable one year in arrears.

Financial position (Extract) of Progrow as at 31 March 2012

Creditors: amounts payable after more than one year $’000

12.5% secured bond ($100 par) 1,320

Issued share capital (25 cents par) 700
Reserves 1,150

The company’s ex-div share price is 162 cents, and bond price 125. Garden tool and jack manufacture
represent 60% and 40% respectively of the company’s total market value.

Required

Advise directors of Progrow whether to expand the garden tool production.

Hilton

The Hilton hotel group is considering building a new luxury hotel in the English resort of Torquay. The
hotel would have a cost of $50 million, ten percent of which is payable immediately, fifty percent
payable in one year’s time and the balance on completion in approximately two years time. This
expenditure is eligible for tax allowable depreciation on a straight line basis at the rate of 10% per
year (note: assume first allowance at the end of year 3). Corporate taxes are levied at the rate of 33%
per year, payable in the year that income arises. Working capital of $1.5 million will be required from
the start of year three.

The hotel is planned with 300 bedrooms. On average, when a bedroom is occupied, 1.4 people per
night are expected to occupy a room. The average room charge per night is expected to be $100,
which is valid whether one or more persons use the room. In addition on average $40 per person per
day is expected to be spent on food and drink, and $15 per person per day on other hotel facilities.
Based upon previous experience the profit margin on food and drink is expected to be 40%, and on
other facilities, 30%.

Non-resident guests are expected to provide an annual contribution to cash flow of $1 million per
year. Annual outlays are expected to be $5.2 million per year.

The group evaluates its hotels over a fifteen operating years time horizon. At the end of fifteen years
of operation the hotel is expected to have an after tax value of $60 million, excluding working capital.

All revenues, costs and values are estimated at current prices. The current level of inflation is 3.8%
per year and this is expected to continue for the foreseeable future.

Hilton Hotel - summarised capital structure

$’m
Net assets 740
Financed by:
Issued ordinary shares (25 cents par) 120
Reserves 270
12% debenture, repayable at par of $100 in 13 years 200
Bank term loans 150
740

The ordinary shares are currently trading at $3.45 per share, and the debentures at $114.

The appropriate government bond yield is 7% and market risk premium is 8%. The hotel has a beta of
0.80. The new hotel is not expected to significantly affect the group's business risk or financial risk.

Required

Evaluate whether the new hotel is financially viable if expected occupancy rate for the hotel is 75%.

Note: You may assumed cost of bank term loan is same as cost of 12% debenture.
Foreign direct investment (FDI)

ABC is a UK company intending to undertake a project in Europe where the currency is the Euro (€).

The initial investment in the project will be €100,000 with revenues over a 2 year project of €150,000
per year and operating costs of $50,000 per year.

The relevant exchange rates for the two years are as follows:

Current Year 1 Year 2

€1.16/£1 €1.18/£1 €1.23/£1

€0.76/$1 €0.77/$1 €0.79/$1

ABC uses a discount rate of 10% to evaluate projects.

UK tax is at 30% and Europe tax at 20%. A bi-lateral tax treaty exists between the UK and the Europe
which permits the offset of overseas tax against any UK tax liability on overseas earnings.

Tax allowances on initial investment are 75% and 25% for the two years and there is no tax delay.

Required

Calculate the NPV of the project.

Novoroast

Novoroast plc manufactures microwave ovens which it exports to several countries, as well as
supplying the home market. One of Novoroasts’s export markets is South American country which
has recently imposed a 40% tariff on imports of microwave ovens in order to protect its local “infant”
microwave industry. The imposition of this tariff means that Novoroast’s products are no longer
competitive in the South American country’s market. However, the South American government is
willing to assist companies wishing to undertake direct investment locally by offering a three years’
tax holiday on earnings. Corporate tax after the three year period would be paid at the rate of 25% in
the year that the taxable cash flow arise.

The total initial cost of a 5-year investment in South America is:

- 50 million pesos for land and buildings;

- 60 million pesos for plant and machinery
- 45 million pesos for working capital.

Working capital needs are expected to increase in line with local inflation.

Plant and machinery is expected to be depreciated (tax allowable) on a straight-line basis over five
years and is expected to have negligible value at the end of the five years. Land and buildings are
expected to appreciate in value with the level of inflation in the South American country.

Production and sales of microwaves are expected to be 8,000 units in the first year at an initial price
of 1,450 pesos per unit, 60,000 units in the second year and 120,000 units per year for the remainder
of the planning horizon. Selling price is expected to increase at 10% per year.

Fixed costs and local variable costs which for the first year of operation are 12 million pesos and 600
pesos per unit respectively are expected to increase by local inflation.

All components will be produced or purchased locally except for essential microchips which will be
imported from the UK at a cost of £8 per unit, yielding a contribution to the profit of the parent
company of £3 per unit. It is hoped to keep this sterling cost constant over the planning horizon.

Corporate tax in the UK is at the rate of 30% per year, payable in the year the liability arises. A bi-
lateral tax treaty exists between the UK and the South American country which permits the offset of
overseas tax against any UK tax liability on overseas earnings. In periods of tax holiday assume that
no UK tax would be payable on South American cash flows.

Novoroast plc believes that if the investment is undertaken the overall risk to investors in the company
will remain unchanged. The company’s beta is 1.25, after tax cost of debt is 5%, market return is 14%,
and risk free rate is 6% per annum.

Novoroast’s current share price is £4.10 per share and current bond price is 80. Forecast inflations are
4% and 20% per annum for the UK and South American country respectively. Current spot rate is
Peso13.421/£1.
 Novoroast plc, summarised financial position £ million
Fixed assets (net) 440
Current assets 370
Less current liabilities (200)
610
Financed by:
Ordinary shares (£1) 200
Reserves 230
430
Bonds 180
610

Required:

Prepare a report to the Board of Directors of Novoroast that:

(a) Assesses whether or not Novoroast plc should invest in the South American country. Show all
relevant calculations. State clearly any assumptions that you make. (20 marks)

(b) Discussion on the limitation of your analysis. (5 marks)

(c) Other information would be useful to assist the decision process (6 marks)

Professional marks for format, structure and presentation of the report. (4 marks)
APV

ABC Co. is considering a project which is expected to generate pre-tax net operating cash flows of
$210,000 per year for 3 years and cost $500,000 of initial investment. 100% of the initial investment
is tax allowable at the end of first year.

ABC has a current equity beta is 1.23 and a current debt to total capital of 25%. Government bond
currently yield 4% and market risk premium is 7%.

To undertake the project the $500,000 (net of issue) will be raised through a 6% bank loan with issue
costs of 0.5% of gross finance.

The tax rate is 30% and payable in the year profit arises.

Required

Calculate the adjusted present value (APV) of the project.

 Tovell

The selection of appropriate discount rates for capital investments has frequently been a problem for
the finance director of Tovell plc. The company has adopted a strategy of diversification into many
different industries, in order to reduce risk for the company’s shareholders. This has resulted in
frequent changes in the company’s gearing level and widely fluctuating risks of individual investments.

The current project under appraisal, an investment in the fast food industry where Tovell has no other
investments, is expected to generate pre-tax operating cash flows of $420,000 in the first year, rising
by 5% per year for the five year expected life of the project. After five years the land and buildings are
expected to have a realisable value of $1,250,000 (after any tax effects), the same as their original
cost. Other fixed assets would have negligible value after five years. The total initial outlay of the
project (net of issue costs) is $2.3 million, and all but the land and buildings attracts a 25% per year
capital allowance on a reducing balance basis.

The project would be financed by a $800,000 fixed rate loan from a regional development agency at
a subsidised interest rate of 6% per year, 3% less than Tovell could borrow at in the capital market.
The remainder of the finance would be provided by an underwritten rights issue, with total
underwriting and issue costs of 5% of gross proceeds. The investment is believed to add $1 million to
the company’s debt capacity.

Current financial data for Tovell and the fast food industry includes
:
Tovell plc Fast Food Industry

Equity beta 1.1 1.4

Debt beta 0.2 0.25
Gearing (debt/equity):
Book values 1.1 to 1 1.6 to 1
Market values 0.4 to 1 1 to 1

The corporate tax rate is currently 30% per year, and tax is payable one year in arrears.

Treasury bills are currently yielding 5% per year, and market return is 12.5% per year.

Required:

Prepare a report for the finance director of Tovell plc:

(i) advising on the financial viability of the proposed fast food investment. Show relevant
calculations.

Notes:

The benefit from the investment in terms of increased debt capacity is $1 million. Although only
$800,000 is being borrowed, the APV should be based upon theoretical benefits of the debt capacity
as these are available to the company and may be used through debt issues for other investments
(these too must be evaluated on their own impact on debt capacity). The tax shield benefit is therefore
based upon $1 million of debt, $800,000 at 6% and the remaining $200,000 at the normal market rate
of 9%.
Foreign direct investment - APV

XYZ is a UK company intending to undertake a project in Europe where the currency is the Euro (€).

The initial investment in the project will be €100,000 with revenues over a 2 year project of €150,000
per year and operating costs of $50,000 per year.

The relevant exchange rates for the two years are as follows:

Current Year 1 Year 2

€1.16/£1 €1.18/£1 €1.23/£1

€0.76/$1 €0.77/$1 €0.79/$1

XYZ has decided to finance the project by borrowing the funds required in Europe. The commercial
borrowing rate is 9% but the local government has offered XYZ a 6% subsidised loan for the entire
amount of the initial funds required. XYZ can borrow at 5% in the UK.

XYZ’s financing consists of 20 million shares currently trading at £2·50 each and £30 million 7% bonds
trading at £1,230 per £1,000. XYZ’s quoted beta is 1.23. The current risk free rate of return is estimated
at 3% and the market risk premium is 6%. Due to the nature of the project, XYZ’s financial gearing will
change.

UK tax is at 30% and Europe tax at 20%. A bi-lateral tax treaty exists between the UK and the Europe
which permits the offset of overseas tax against any UK tax liability on overseas earnings.

Tax allowances on initial investment are 75% and 25% for the two years and there is no tax delay.

Required

Calculate the APV of the project.