CORPORATE FINANCE
Thefollowingassignmentbringstogether manyoftheissuesthat areraised while studying capital budgetinginUnit 1 ofthestudyguide.Thisassignmentwill count for20%of thetotal marks.
BirminghamAirwaysplcisa largeprofitablefirmcurrentlyconsidering anewproject involvingan investmentoutlayof£1million. Thefirmhasdecidedtofinance theproject50 percent bydebtand 50percent byequity.
Theprojectwill require working capital each year amounting to10%ofannual sales revenue; thismust bein placeat theendof theprevious year. At theendofthe project’slife (year4)thefirm will recoveranyremaining investment in working capital.All revenuesand expensesoccurat theend ofeach year.
Themanagement accountant hasdrawn up thefollowing forecast incomestatementfor the project (allfiguresin nominal terms):
Year 1 2 3 4
Sales revenue 400,000 400,000 500,000 500,000
Operating expenses −80,000 −100,000 −120,000 −120,000
Intereston debt −84,000 −84,000 −85,000 −85,000
Advertisingcosts −50,000 −50,000 −50,000 −50,000
Salvage value 20,000
Netprofit beforetax
−64,000
−84,000 −5,000 −5,000
Netprofit aftertax(@35%) −41,600 −54,600 −3,250 −3,250
Otherinformationis asfollows:
a) Capital allowance is allowablefortaxpurposes at25%onareducingbalance basisand anyprofit or loss ondisposalattractsan immediate balancingcharge.
b) Thefirmpaystaxes with nolag. Thecorporationtaxrateis35%. c) Debtholdersrequire a10%return.
d)Shareholdersrequire areturnof19%.
e) Thefirmhasalreadyinvested£100,000 inmarket researchfor theprojecttogenerate the above incomestatementfigures.Thisamountisomittedfrom theabove figures. Also omitted istheproject’sshare ofallocatedR&D coststhat thecompanyspreads across investment projects.The companyhasafixed annual R&D budget of£3mand will allocate 2%ofthisexpenditureeach year tothe projectasan overheadcharge.
f) Theadvertising chargeis theproject’sshare of thefirm’scorporate advertising bill; however,thefirmhasnointention of changing the amountspenton corporate advertisinginresponseto itsdecision onthisproject.
g) No subsequentcapital budgeting decisionsreston theaccept/rejectdecisionfor this project.
h) Theprojectrequires some special equipmentin itsfirst year.Another projecthas been using the equipment, but thisproject isdueto end. Thecompanytherefore proposestomakenochargeforusing the equipment onthe project.However,the store’smanager knowsshe can hireout thisequipmentfor£20,000 if thecompany hasno usefor it.
Required
a) Calculate the expectedincremental after-taxcashflowsfortheprojectand hencefind
theproject’sNPV.Should thefirmaccept orreject the project?Explain carefully whichfigures you have included orexcluded in yourcalculations.(60marks)
b) What istheproject’sIRR and whatisitspaybackperiod? (15marks)
c) “TheIRR rule isredundantasan investment criterion becausethenet presentvalue (NPV)rulealwaysdominates it.”Discussthisstatementgivingexampleswhere possible. (25marks)
Theword limit foranswerstoquestions(a), (b)and (c)is2000 excluding tables and references.