Finance Assignment – Investment Appraisal 2015

| September 29, 2018

Topic:
investment appraisal

Case
material:
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.
Project A
This project is an expansion of existing business
costing $3·5 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.

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