ACCA-FM

1. ABBEY CO CHAPTER 3- INVESTMENT APPRAISAL

The following draft appraisal of a proposed investment project has been prepared for the finance director of
ABBEY Co by a trainee accountant. The project is consistent with the current business operations of ABBEY Co.

Net present value = 1,645,000 – 2,000,000 = ($355,000) so reject the project. The following information was
included with the draft investment appraisal: THE WACC HAS TAKEN in
1. The initial investment is $2 million. ACCOUNT OF INTERST
2. Selling price: $12/unit (current price terms), selling price inflation is 5% per year.
3. Variable cost: $7/unit (current price terms), variable cost inflation is 4% per year.
4. Fixed overhead costs: $500,000/year (current price terms), fixed cost inflation is 6% per year. INTEREST=irrelevant
5. $200,000/year of the fixed costs are development costs that have already been incurred and are being
recovered by an annual charge to the project. SUNK COSTS
6. Investment financing is by a $2 million loan at a fixed interest rate of 10% per year.
7. ABBEY Co can claim 25% reducing balance tax allowable depreciation on this investment and pays taxation
one year in arrears at a rate of 30% per year.
8. The scrap value of machinery at the end of the four-year project is $250,000.
9. The real weighted average cost of capital of ABBEY Co is 7% per year. CHANGE FROM REAL RATE TO
10. The general rate of inflation is expected to be 4.7% per year. NOMINAL RATE
Required:

Prepare the revised calculation of the net present value of the proposed investment project and comment on
the project’s acceptability.
(1+M)=(1+R)(1+I)
1+M=(1+0.07)(1+0.047)
1+M=1.12
M=12%

1
JENNIFER LEE
 ACCA-FM

2. FRUITY CO

FRUITY Co has developed a new confectionery line that can be sold for $5.00 per box and that is expected to
have continuing popularity for many years. The Finance Director has proposed that investment in the new
product should be evaluated over a four-year time horizon, even though sales would continue after the fourth
year, on the grounds that cash flows after four years are too uncertain to be included in the evaluation. The
variable and fixed costs (both in current price terms) will depend on sales volume, as follows:

i. The production equipment for the new confectionery line would cost $2 million and an additional initial
investment of $750,000 would be needed for working capital.
ii. Tax allowable depreciation (tax-allowable depreciation) on a 25% reducing balance basis could be
claimed on the cost of equipment.
iii. Profit tax of 30% per year will be payable one year in arrears. PAID IN SUBSEQUENT YEARS
iv. A balancing allowance would be claimed in the fourth year of operation.
v. The average general level of inflation is expected to be 3% per year and selling price, variable costs, fixed
costs and working capital would all experience inflation of this level.
vi. FRUITY Co uses a nominal after-tax cost of capital of 12% to appraise new investment projects.

Required:

If production only lasts for four years, calculate the net present value of investing in the new product using a
nominal terms approach and advise on its financial acceptability (work to the nearest $1,000).

2
JENNIFER LEE
ACCA-FM

3. SAMMY CO

SAMMY Co is planning to expand its operation by increasing the production capacity of its current operation.
You are appointed by the Finance Director to estimate the discount rate to be used in appraising a large new
capital investment provided with the following information as follows:

Estimates for the next five years (annual averages):

Stock market total return on equity: 16%

Dividend yield: 7%

Share price rise: 14%

Equity Beta: 1.4

Growth rate in earnings: 12%

Growth rate in dividends: 11% Growth rate of dividend, G

Growth rate in company sales: 13%

Dividend per shares
Treasury bill yield: 12% =$2140,000/10m
=$0.214
The company’s gearing level (by market values) is 1:2 debt to equity, and after-tax earnings available to
ordinary shareholders in the most recent year were $5,400,000, of which $2,140,000 was distributed as
ordinary dividends.

The company has 10 million issued ordinary shares, which are currently trading on the Stock Exchange at 321
cents.
Current shares price (P0)=$3.21
Corporate debt may be assumed to be risk-free. The company pays tax at 35% and personal taxation may be
ignored.

Required:

a) Estimate the company’s weighted average cost of capital using:

i. the dividend valuation model
ii. the capital asset pricing model.

3
JENNIFER LEE
ACCA-FM

4. BAMBINO

The finance director of BAMBINO Co has heard that the market value of the company will increase if the
weighted average cost of capital of the company is decreased.

The company, which is listed on a stock exchange, has 100 million shares in issue and the current ex div
ordinary share price is $2.50 per share. BAMBINO Co also has in issue bonds with a book value of $60 million
and their current ex interest market price is $104 per $100 bond. KD-BONDS
PO=$104
Kd
The current after-tax cost of debt of BAMBINO Co is 7% and the tax rate is 30%.

The recent dividends per share of the company are as follows. N=4 years' growth D0=$0.218
Latest dividend paid
Year 2012 2013 2014 2015 2016
Dividend per 19.38 20.20 20.41 21.02 21.80
share (cents)

The finance director proposes to decrease the weighted average cost of capital of BAMBINO Co, and hence
increase its market value, by issuing $40 million of bonds at their par value of $100 per bond. These bonds
would pay annual interest of 8% before tax and would be redeemed at a 5% premium to par after 10 years.
Redemption Price
Required: =100*1.05
=$105
Calculate the market value after-tax weighted average cost of capital of BAMBINO Co in the following
circumstances:

i. before the new issue of bonds takes place just calculate ke, kd in the question Interest of the bonds
ii. after the new issue of bonds takes place. =Interest(1-T)
KE -(PART 1) PO=$100 ( REDEMPTION PRICE) =$100*8%(1-0.3)
KD- (PART 1) =$8(1-0.3)
NEW KD=IRR =5.60%

KD of the bonds
=5.6%

4
JENNIFER LEE
ACCA-FM

no of right issues Total no of shares

=$5m/ $4 =10000+1250
5. SAKURA =1250k of shares =11250 of shares
SAKURA Ltd plans to raise $5m to expand its existing chain of retail outlets. It can raise the finance by issuing
10% loan stock redeemable in ten years’ time, or by a rights issue at $4.00 per share. The current financial
statements of SAKURA are as follows: Total interest paid
Interest for the loan stock
=10% *5m =500+300
=500 =800

Cost of sales will increase by 12% since the sales

increases 12%
=$30000*1.12
=$33600
New Variable cost of sales
=85% of COS
=85%*$33600
=28560

Assets

Capital & Liabilities

No of shares=$2500/$0.25
=10000k of shares
Interest
=2500*12%
=300 COST OF SALES
=85% VARIABLE COST
=15% FIXED COST
The expansion of business is expected to increase sales revenue by 12% in the first year. Variable cost of sales
makes up 85% of cost of sales. Administration costs will increase by 5% due to new staff appointments.
SAKURA Ltd has a policy of paying out 60% of profit after tax as dividends and has no overdraft.

Required:

a) For each financing proposal, prepare the forecast statement of profit or loss after one additional year of
operation.

Fixed costs= Admin costs+ Fixed cost of sales

5
JENNIFER LEE
ACCA-FM

b) Evaluate and comment on the effects of each financing proposal on the following:

(i) Financial gearing =Fixed costs/ total costs

(ii) Operational gearing

(iii) Interest cover

(iv) Earnings per share.

c) Comment on the view that businesses are unlikely to have high financial gearing and high operating
gearing.

6
JENNIFER LEE
ACCA-FM

6. SOLOMON

SOLOMON Co is a major supermarket chain which is committed to significant growth over the next five years.
To help achieve this, the board of directors of SOLOMON Co is considering the acquisition of SONIA Co. The
board believes that the acquisition of this company would lead to significant operating and financial synergies.
SONIA Co is a smaller supermarket chain that is listed on the same stock exchange as SOLOMON Co and which
has enjoyed steady, but unspectacular, growth.

The draft financial statements of SONIA Co for the most recent financial year are set out below.

7
JENNIFER LEE
 ACCA-FM

An independent valuer has provided the following estimates of the current realisable values of the assets of
SONIA Co: NPV
$m

Land and buildings 95·6

Motor vehicles 6·5

Fixtures and fittings 5·2

Inventories 14·2

The current realisable value of trade receivables was considered to be in line with their values in the statement
of financial position.
KE
The required return from ordinary shareholders in similar quoted companies is 8%. The average price/earnings
ratio for similar listed businesses is 11·5 times.

The profit for SONIA Co for the forthcoming year is expected to be the same as for the year that has just ended.
The current dividend payout ratio of the company is 20% but this will change as dividends are expected to grow
at the rate of 4% per year for the foreseeable future.Dividend Payout ratio based of PAT Dividend per shares
=20% 0F PAT =Total Dividend/no of
Required: =20%*$10M shares
=2M =$2m /40 m of shares
a) Calculate the value of an ordinary share in SONIA Co using the following valuation methods:
i. net assets (net book value) basis; =$0.05
ii. net assets (liquidation) basis;
iii. dividend growth basis; and
iv. price earnings ratio basis.

b) Briefly evaluate each of the share valuation methods in (a) above and state, with reasons, which one is
likely to provide the most realistic assessment of the market value of an ordinary share in SONIA Co.

A)(I) Net assets (net book value) basis a(iii) Dividend Growth Model
PO= NET ASSETS AT balance sheets values/ no of ordinary shares PO=DO(1+G)/(KE-G)
PO=64.5/ (20/0.5) PO=$0.05(1+0.04)/(0.08-0.04)
PO=$1.61 PER SHARES PO=$1.30

A(II)Net assets (liquidation basis) A)(IV) PE RATIO BASED VALUATION

PO=Net assets at realisable value / no of ordinary shares P0=PE Ratio*Earnings per shares (EPS)
PO=($95.6 +6.5 +5.2 +14.2 +0.9+13.6)M -(37.6+11M )/40 M P0=11.5*$0.25
P0=$2.19 P0=$$2.88

EPS=$10M/40 M
EPS=$0.25
8
JENNIFER LEE