Sebastian Trains Co (ST) is a UK based rail operating company which holds three UK rail franchises. The franchises allow ST to run trains on the rail network in a particular geographical area within the UK. All three of the franchises have been profitable over the last 2 years, and they are all up for renewal in 3 years’ time.

ST is a listed company in the UK, where the functional currency is the British pound (£), and its most recent accounts show an operating profit of £58.9 million and revenue of £206.8 million.

The directors are keen to diversify the company’s operations geographically, in order to reduce their reliance on the volatile UK market, and to try to avoid the potential problem of having all franchises up for renewal at the same time. An opportunity has arisen for ST to apply for a 5 year rail franchise in Middland, where the currency is the Middland dollar (M$). The current rate of exchange for the M$ to the British pound is M$ 1.2525 per £1.

If ST were to win the franchise, a fee of M$ 10 million would be payable immediately to the Middland Rail Authority, followed by an annual fee of M$ 5 million (nominal cash flow) each year thereafter. These amounts would not be tax deductible.

In order to satisfy the terms of the franchise, ST would have to purchase 2 new trains, at a total cost of M$ 26 million, and to invest £6 million immediately in the UK to renovate 2 other trains which have been owned by ST for many years but have been surplus to requirements in recent years. Under the terms of the franchise, the M$ capital expenditure would qualify for a 50% first year tax depreciation allowance in Middland. The balance of the M$ expenditure would be claimed in equal instalments over the remaining 4 years of the franchise. The £ capital expenditure would qualify for a 100% first year tax depreciation allowance in the UK.

Total passenger journey numbers are expected to be 1 million in the first year of the Middland franchise, but it is thought that a nominal cash flow investment of M$ 1.25 million per year in marketing (starting in 1 year’s time) should help to create extra demand, leading to a 5% per year (compound) increase in passenger numbers over the term of the franchise. The average fare per passenger journey is currently M$ 40, but the terms of the franchise allow for this to be increased in line with Middland inflation over the term of the franchise. Other costs associated with running trains for the Middland franchise are forecast to be:

- fixed costs of M$ 10 million (in current terms),
- variable costs per passenger journey, which amount to 25% of fares on average.

UK inflation is forecast to be 3.7% per year and Middland inflation is forecast to be 2.2% per year. Both of these rates are expected to stay constant for the foreseeable future.

The UK tax rate is 28% and the Middland tax rate is 30%. In both cases, tax is paid at the end of the period in which any profit is made. A double tax treaty exists, meaning that income which has already been taxed in Middland is not liable to further tax after it has been remitted to the UK.

ST appraises prospective franchise investment opportunities using the following procedure:

- the net present value method is used in the first place, based on the assumption that the net M$ denominated cash flows will be converted into £ and remitted back to the UK. The final NPV is then computed in £.
- as an alternative to NPV, the Modified Internal Rate of Return is also computed.
- all cash flows are assumed to arise at the end of the year concerned, except the initial franchise payment and capital expenditure.
- the post-tax residual value of the 2 new trains at the end of the franchise is assumed to be 20% of the initial cost, adjusted for local inflation. The two other trains being renovated for the project would have no residual value.
- ST’s real cost of capital is 6.1%.

Required:
(a) Prepare a schedule showing the nominal post tax cash flows projected for the Middland franchise project, and calculate the project’s NPV. (13 marks)
(b) Calculate the project’s Modified Internal Rate of Return. (3 marks)
(c) Assess the likely viability of the project, taking into account the results of your analysis in parts (a) and (b) above, and any other factors which you consider to be important. (4 marks)

Professional marks will be awarded for the demonstration of skill in analysis and evaluation, and scepticism in your answer.