Hydra plc (Hydra) is a UK based manufacturer of battery powered automatic weather station. The company directors are thinking of moving away from battery power and into environmentally friendly renewable energy, by developing solar powered automatic weather station (AWS). The financial statements for Hydra for the years ended 31 December 2019 and 2020 show the following information:

Required: a) The companys long term loan includes bonds that were issued five years ago at a par value of 100 (total raised 0.5m). They carry an annual coupon of 5%, are due to be redeemed in four years, and are currently trading at 105. Estimate the after-tax cost of this debt capital.

b) Calculate the Net Present Value (NPV) of the above project using the cost of capital provided in point 10 above. Include in your answer the assumptions you make and make a recommendation as to whether the investment should go ahead.

c) Critically discuss some practical difficulties associated with using NPV as a method of evaluating a new project. 10 marks

Income Statement for the year ended 31 December 2020 2020 '000 Revenue 1,712 Cost of Sales (1,200) Gross Profit 512 Selling Expenses (200) Administration Expenses (80) Finance Costs (130) Profit for the financial year 102 2019 '000 1,600 (1,170) 430 (150) (76) (92) 112 Balance Sheet as at 31 December 2020 2020 '000 1,600 2019 '000 1,340 Non Current Assets Current Assets Inventories Trade Receivables Bank 250 340 230 283 590 2,190 513 1,853 Total Assets Current Liabilities Trade Payables Bank (250) (150) (400) (165) (100) (265) (1,100) (1,500) 690 (1,000) (1,265) 588 Non Current Liability Long Term Loan Total Liabilities Net Assets Equity Ordinary Shares of 1 Retained Earnings Total Equity 300 390 690 300 288 588 Ms Amelia May, the Finance Director of Hydra identified that the current infrastructure cannot support this new venture, as the solar powered automatic weather station (AWS) will require manufacturing of new mechanical components and development of advance electronics. If the proposal goes ahead this will involve hiring new employees, moving into larger premises, and purchasing new equipment. Ms May compiled the following information, relevant to the new project. 1. Six new machines will be required to develop the solar powered automatic weather station, at a cost of 270,000 each. The expected life of the machines is 3 years, and they will have a scrap value at the end of year 3 of 31,500 each. The company's policy is to depreciate assets over their useful life, using the straight-line method of depreciation. 2. The development of solar panels will require hiring 2 new electrical engineers and 1 new solar energy engineer - all on three-year contracts. The starting salary of an electrical engineer is 107,000 per annum, while the salary for Solar Energy engineer is 127,000 per annum 3. Extensive market research, at a cost of 137,000, has been undertaken to ensure there is sufficient demand for the Solar Powered AWS. This will be paid for at the beginning of Year 1. 4. The Solar powered AWS will be sold to a network of Weather stations and distributors around Europe. The selling price and costs per Solar powered AWS is as follows: Selling price 8,100 Raw materials 3,800 Variable overheads 2,480 5. The selling price per solar powered automatic weather station will rise by 2% per annum over the next 3 years. 6. The demand for the raw materials for solar panel (silicon, lithium and nickel) has increased in the past few years. The directors are concerned that inflation of the raw material cost will have an adverse effect on the project's cash flows. The firm expects that the raw material cost per batch will rise by 6% per annum over each of the next 3 years. 7. All other costs will rise by 3% per annum. 8. The company will need to hire new premises, which will cost 205,000 per annum. 9. Sales are expected to be: Year 1 900 AWS units Year 2 1,250 AWS units Year 3 1,300 AWS units 10. The cost of capital is currently 6% per annum, after adjusting for inflation which is expected to be 2% 11. The company pays tax on its taxable profit at 20%. This is payable in the same year the profit is earned. 12. Capital allowances are currently given at a reducing balance rate of 18%. Whilst Hydra's directors are committed to the project, they have not decided whether to finance it using debt or equity. Following the turmoil around the world due to Covid-19, local economic issues due to Brexit and the slow global economy, financial analysts have predicted volatility in interest rates. Investors are also wary of buying equity with fears of a looming recession. A range of standard financing options is being considered, including bank loans, convertible bonds, and preference shares. Hydra owns real estate in Glasgow, which is on the rental market and is expected to generate a rent of 142,000 per annum. One option is to issue Sukuk al-Ijarah against the building in Glasgow. Hydra is also successfully operating a mobile app that provides local weather forecast to hikers and climbers, by combing the secondary data with the data gathered from its own AWEs. Driven by the success of it mobile app and inspired by the eco-system of Ali-Baba's Ant-Financial Services and success of Fintech, it is also thinking of creating a new platform that offers range of financial services. Hydra wants to create a peer-to-peer lending, alongside other Fintech services within the new platform, where the local weather stations can generate funding to purchase its solar powered automatic weather station (AWS) units. Hydra has no prior experience of the financial world, but in the past, it has created a robo-advisers, and a local bank has also shown interest in partnering with them. As part of a deal to enter the American market, Hydra has opened discussion with an installer and distributor in the USA. To set up the deal, Hydra needs to pay US$ 105,000 in six months' time. The foreign-exchange spot-rate as of today is US$1.35/. Ms May forecasts the future spot-rate in six months as follows: Forecast future spot rate Probability $1.20/ 0.5 $1.50/ 0.3 $1.85/ 0.2 Income Statement for the year ended 31 December 2020 2020 '000 Revenue 1,712 Cost of Sales (1,200) Gross Profit 512 Selling Expenses (200) Administration Expenses (80) Finance Costs (130) Profit for the financial year 102 2019 '000 1,600 (1,170) 430 (150) (76) (92) 112 Balance Sheet as at 31 December 2020 2020 '000 1,600 2019 '000 1,340 Non Current Assets Current Assets Inventories Trade Receivables Bank 250 340 230 283 590 2,190 513 1,853 Total Assets Current Liabilities Trade Payables Bank (250) (150) (400) (165) (100) (265) (1,100) (1,500) 690 (1,000) (1,265) 588 Non Current Liability Long Term Loan Total Liabilities Net Assets Equity Ordinary Shares of 1 Retained Earnings Total Equity 300 390 690 300 288 588 Ms Amelia May, the Finance Director of Hydra identified that the current infrastructure cannot support this new venture, as the solar powered automatic weather station (AWS) will require manufacturing of new mechanical components and development of advance electronics. If the proposal goes ahead this will involve hiring new employees, moving into larger premises, and purchasing new equipment. Ms May compiled the following information, relevant to the new project. 1. Six new machines will be required to develop the solar powered automatic weather station, at a cost of 270,000 each. The expected life of the machines is 3 years, and they will have a scrap value at the end of year 3 of 31,500 each. The company's policy is to depreciate assets over their useful life, using the straight-line method of depreciation. 2. The development of solar panels will require hiring 2 new electrical engineers and 1 new solar energy engineer - all on three-year contracts. The starting salary of an electrical engineer is 107,000 per annum, while the salary for Solar Energy engineer is 127,000 per annum 3. Extensive market research, at a cost of 137,000, has been undertaken to ensure there is sufficient demand for the Solar Powered AWS. This will be paid for at the beginning of Year 1. 4. The Solar powered AWS will be sold to a network of Weather stations and distributors around Europe. The selling price and costs per Solar powered AWS is as follows: Selling price 8,100 Raw materials 3,800 Variable overheads 2,480 5. The selling price per solar powered automatic weather station will rise by 2% per annum over the next 3 years. 6. The demand for the raw materials for solar panel (silicon, lithium and nickel) has increased in the past few years. The directors are concerned that inflation of the raw material cost will have an adverse effect on the project's cash flows. The firm expects that the raw material cost per batch will rise by 6% per annum over each of the next 3 years. 7. All other costs will rise by 3% per annum. 8. The company will need to hire new premises, which will cost 205,000 per annum. 9. Sales are expected to be: Year 1 900 AWS units Year 2 1,250 AWS units Year 3 1,300 AWS units 10. The cost of capital is currently 6% per annum, after adjusting for inflation which is expected to be 2% 11. The company pays tax on its taxable profit at 20%. This is payable in the same year the profit is earned. 12. Capital allowances are currently given at a reducing balance rate of 18%. Whilst Hydra's directors are committed to the project, they have not decided whether to finance it using debt or equity. Following the turmoil around the world due to Covid-19, local economic issues due to Brexit and the slow global economy, financial analysts have predicted volatility in interest rates. Investors are also wary of buying equity with fears of a looming recession. A range of standard financing options is being considered, including bank loans, convertible bonds, and preference shares. Hydra owns real estate in Glasgow, which is on the rental market and is expected to generate a rent of 142,000 per annum. One option is to issue Sukuk al-Ijarah against the building in Glasgow. Hydra is also successfully operating a mobile app that provides local weather forecast to hikers and climbers, by combing the secondary data with the data gathered from its own AWEs. Driven by the success of it mobile app and inspired by the eco-system of Ali-Baba's Ant-Financial Services and success of Fintech, it is also thinking of creating a new platform that offers range of financial services. Hydra wants to create a peer-to-peer lending, alongside other Fintech services within the new platform, where the local weather stations can generate funding to purchase its solar powered automatic weather station (AWS) units. Hydra has no prior experience of the financial world, but in the past, it has created a robo-advisers, and a local bank has also shown interest in partnering with them. As part of a deal to enter the American market, Hydra has opened discussion with an installer and distributor in the USA. To set up the deal, Hydra needs to pay US$ 105,000 in six months' time. The foreign-exchange spot-rate as of today is US$1.35/. Ms May forecasts the future spot-rate in six months as follows: Forecast future spot rate Probability $1.20/ 0.5 $1.50/ 0.3 $1.85/ 0.2