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The directors of Merchant pic are considering a five year project that has been proposed by the company's sales director. A customer is about to sell a very specialised milling machine that has become surplus to requirements, This type of michine would cost tens of millions of pounds to buy new. Used machines are rarely sold on the open market. The machine has an expected remaining useful life of five years and has been checked and certified by an independent engineer. The sales director proposes buying the used machine for E4 million and using it to manufacture a new product for which Merchant plc owns some patent rights and which cannot be manufactured in an economic marmer without such equipment. The sales director proposes taking out a five year lease on a factory building and using an employment agency to provide labour for the five year period. The sales director estimates that it would be necessary to invest a further E1 million at the start of the first year in addition to buying the machine a returnable deposit of E100,000 on the factory, $200,000 for the first year's lease, E400,000 for the opening inventory of raw materials and E300,000 for the initial payment for labour. The sales director has drafted the following budgeted annual income statement for the project: Em Revenue 2.6 Raw materials (0.4) Factory lease (0.2) Labour (0.3) Depreciation of machine (0.8) Other running costs (0.5) Profit 0.4 It is anticipated that materials, recurring lease payments and labour will be paid for annually at the start of each year. Other running crusts comprise the cost of electricity and other operating costs and they will be paid for annually at the end of each year. Revenues will be received at the end of the year in which they are earned. At the conclusion of the project, the sales director anticipates that it will cost E300,000 to dismantle the equipment and at that time it will be possible to reclaim 100% of the deposit paid to the factory owner. The sales director has shown this proposal to a potential lender, who has agreed to lend Merchant plc 65 million at an interest rate of 7% pa. This loan will be secured on Merchant plc's existing assets because the milling machine is deemed to be too specialised to be a suitable form of security. The sales director proposes that the project should be evaluated at a required rate of iturn of 7% pa because it will be financed by means of a self-contained loan package upon which that rate will be changed The finance director believes that the project should be evaluated at a much higher rate than 7% pa, but cannot state the specific rate that should be charged without conducting a further analysis. 2 A2010-8 The finance director is also concerned that the sales director has ignored tax when preparing the budgeted income statement. (i) Calculate the net present value of the project using a discount rate of 7% pa and ignoring tax. [8] (ii) Explain why the required rate of return might be higher than the 7% rate charged by the bank on the funding for the project. [6] (iii) Explain how adjusting for tax will affect the analysis of this project. You are not required to calculate the effects of tax. [6] [Total 20]An individual purchases $100,000 nominal of a bond on 1 January 2003 which is redeemable at 105% in four years time and pays coupons of 4% per annum at the end of each year. The investment manager wishes to invest the coupon payments on deposit until the bond is redeemed. It is assumed that the rate of interest at which the coupon payments can be invested is a random variable and the rate of interest in any one year is independent of that in any other year. Deriving the necessary formulae, calculate the mean value of the total accumulated investment on 31 December 2006 if the annual effective rate of interest has an expected value of 512% in 2004, 6% in 2005 and 42 % in 2006. [5]An individual purchases (100,000 nominal of a bond on 1 January 2003 which is redeemable at 105% in four years time and pays coupons of 4% per annum at the end of each year. The investment manager wishes to invest the coupon payments on deposit until the bond is redeemed. It is assumed that the rate of interest at which the coupon payments can be invested is a random variable and the rate of interest in any one year is independent of that in any other year. Deriving the necessary formulae, calculate the mean value of the total accumulated investment on 31 December 2006 if the annual effective rate of interest has an expected value of 51%% in 2004, 6% in 2005 and 412 % in 2006. [5]