Question
Maryhill Fabrics is considering an investment opportunity to expand their soft furnishings market share. They have identified a new building which they can rent for
Maryhill Fabrics is considering an investment opportunity to expand their soft furnishings market share. They have identified a new building which they can rent for 25,000 a year and have estimated that machinery requirements for the project can be bought from their current capital budget for 720,000. It is estimated the machinery acquired will have a resale value at the end of the project of 90,000. The project will last for five years.
The company's accountants have produced the following estimate of financial performance for each year of the project's life:
Sales: 440,000
Labour costs 110,000
FMaterial costs 68,000
Rent 25,000
Overheads 25,000
Interest on borrowings 28,000
Depreciation 126,000
Market research 10,000
Net Profit 58,000
Company management has decided that only projects with a payback period of less than four years will be considered for further assessment. Clearly, this project would not achieve this target but you have been asked to re-assess the project, identifying actual cash flows and calculating the Net Present Value of the project.
The following information is relevant:
i. The provision for overheads includes an allocation of 10,000 of existing costs, the remaining overheads being directly related to the project.
ii. The company has 50% of the material requirement for the first year of the project in stock, bought for 25,000 three years previously and, if not used for the contract, can only be sold for its scrap value of 6,000.
iii. Market research, completed six months previously, cost 50,000 in total and is being written off through the life of the project.
iv. Interest on borrowings refers to a loan at 12% the company raised for half the capital cost of the project. The loan will be repaid in full on completion
v. Additional management resources will be required at a cost of 35,000 each year. Provision for this expenditure has not been included in the figures shown.
vi. The company is funded 70% from Equity and 30% from Debt finance. The company's Equity Beta is 1.2, the Market Premium is 8% and the Risk-Free return is 4%. The cost of debt is 9.6%.
Required:
a) Identify the relevant costs of the project and calculate its Net Present Value ignoring the possible impact of taxation.
(12 marks)
b) Calculate the annual allowances available to the company to offset against taxation if they are allowed 25% reducing balance Capital Allowances for the five year life of the project.
(8 marks)
3. (a) Keavagh Partners, a company providing technical analysis services in the oil industry, is financed from both Ordinary Shares and Long-Term Bonds with a coupon rate of 8%. The company has issued 8 million shares at flotation, currently trading at 3.30 per share, and recently raised 6 million through the bond issue. The bonds are trading today at 96 per 100 bond. Financial analysts have calculated an appropriate Beta for the company would be 1.4, given its business and financial risk levels. The risk free rate is 3.5% and the market premium is 8%. The tax rate applicable to company operations is 28%.
Calculate Keavagh's Weighted Average Cost of Capital.
(12 marks)
(b) Debt in the capital structure enhances value. Discuss, illustrating your answer as appropriate.
Based on the projected cash flows, the NPV for this project is negative, which is an indication that it is not a worthwhile investment opportunity for company. they might not make a return
Step by Step Solution
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Step: 1
a To calculate the Net Present Value NPV of the project we need to identify the relevant costs and cash flows Heres the breakdown 1 Sales 440000 2 Lab...Get Instant Access to Expert-Tailored Solutions
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Step: 3
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