Advanced: Relevant cash flows and taxation plus a calculation of the weighted average cost of capital Ceely pic is evaluating a high risk project in a new industry. The company is temporarily short of accountants, and has asked an unqualified trainee to produce a draft financial evaluation of the project. This draft is shown below:

The net present value is - £2 067 000 Conclusion: The project is not financially viable and should not be undertaken.
Notes:
1 Year 0 is the present time, year 1 one year in the future etc.
Cash flows have been discounted at a high rate because of the high risk of the project.
Assume that you have been engaged as a financial consultant to Ceely pic. The following additional information is made available to you.
(i) The company has a six year planning horizon for capital investments. The value of the investment at the end of six years is esti¬ mated to be five times the after tax operating cash flows of the sixth year.
(ii) The project would be financed by two 15% debentures, one issued almost immediately and one in a year’s time. The debentures would both have a maturity of 10 years.
(iii) 50% of the overheads would be incurred as a direct result of undertaking this project.
(iv) Corporate taxation is at the rate of 40% payable one year in arrears.
(v) Tax allowable depreciation is on a straight- line basis at a rate of 20% per year on the full historic cost of depreciable fixed assets. Land and buildings are not depreciable fixed assets and their total value is expected to be £1.1 million at the end of year six.
(vi) The company is listed on the USM. Its current share price is £2.73, and its equity beta coefficient value is 1.1.

(vii)The yield on Treasury Bills is 12% per year, and the average total yield from companies forming the Financial Times Actuaries All Share Index is 20% per year.
(viii) Interest rates are not expected to change significantly.
(ix) The equity beta value of a company whose major activity is the manufacture of a similar product to that proposed in Ceely’s new project is 1.5. Both companies have gearing levels of 60% equity and 40% debt (by market values). Ceely’s gearing includes the new debenture issues.
Required:

(a) Modify the draft financial evaluation of the project, where appropriate, to produce a revised estimate of the net present value of the project. Recommend whether the project should be accepted, and briefly discuss any reservations you have about the accuracy of your revised appraisal. State clearly any assumptions that you make. (20 marks)

(b) You are later told that the draft cash flow esti¬ mates did not include the effects of changing prices. Discuss whether, on the basis of this new information, any further amendments to your analysis might be necessary. (5 marks)
(Total 25 marks) ACCA Level 3 Financial Management

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Year' (000) 0 2 3 5 6 Cash outflows Long term capital: Land and buildings 500 600 Plant and machinery 700 1700 Working capital (cumulative requirement) 230 Sales 570 680 2950 3820 5200 700 720 740 740 5400 5600 5800 Direct costs: Materials 487 630 858 891 924 957 Labour 805 1043 1420 1474 1529 1583 Selling and 207 267 364 378 392 406 distribution 1499 1940 2642 2743 2845 2946 Overheads 370 Interest 480 214 610 610 630 6421 655 660 610 610 610 Depreciation 240 700 700 700 700 460 Total cost 2323 3730 4582 4695 4810 4676 Net profit before tax 627 90 618 705 790 1124 Taxation at 40% 251 36 247 282 316 450 Net profit after 376 54 371 423 474 674 taxation Net cash flows (1200) (1924) 54 371 423 474 674 Cash flows discounted at 30% per year (1200) (1480) 32 169 148 124 140