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32 DD Co has a dividend payout ratio of 40% and has maintained this payout ratio for several years. The current dividend per share of the company is $0-50 per share and it expects that its next dividend per share, payable in one year's time, will be $0-52 per share. The capital structure of the company is as follows: 5m Sm Equity Ordinary shares (nominal value $1 per share) 25 Reserves 35 60 Debt Bond A (nominal value $100) 20 Bond B (nominal value $100) 10 30 90 Bond A will be redeemed at nominal in ten years' time and pays annual interest of 9%. The cost of debt of this bond is 9-83% per year. The current ex interest market price of the bond is $95-08. Bond B will be redeemed at nominal in four years' time and pays annual interest of 8%. The cost of debt of this bond is 7-82% per year. The current ex interest market price of the bond is $102-01. DD Co has a cost of equity of 12-4%. Ignore taxation. Required: (a) Calculate the following values for DD Co: (i) ex dividend share price, using the dividend growth model; (3 marks) (i) capital gearing (debt divided by debt plus equity) using market values; and (2 marks) (ii) market value weighted average cost of capital. (2 marks) (b) Discuss whether a change in dividend policy will affect the share price of DD Co. (8 marks) (c) Explain why DD Co's capital instruments have different levels of risk and return. (5 marks) (20 marks)Section C - BOTH questions are compulsory and MUST be attempted Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet. 31 PV Co, a large stock-exchange-listed company, is evaluating an investment proposal to manufacture Product W33, which has performed well in test marketing trials conducted recently by the company's research and development division. Product W33 will be manufactured using a fully-automated process which would significantly increase noise levels from PV Co's factory. The following information relating to this investment proposal has now been prepared: Initial investment $2 million Selling price (current price terms) $20 per unit Expected selling price inflation 3% per year Variable operating costs (current price terms) $8 per unit Fixed operating costs (current price terms) $170,000 per year Expected operating cost inflation 4% per year The research and development division has prepared the following demand forecast as a result of its test marketing trials. The forecast reflects expected technological change and its effect on the anticipated life-cycle of Product W33. Year 2 3 Demand (units) 60,000 70,000 120,000 45,000 It is expected that all units of Product W33 produced will be sold, in line with the company's policy of keeping no inventory of finished goods. No terminal value or machinery scrap value is expected at the end of four years, when production of Product W33 is planned to end. For investment appraisal purposes, PV Co uses a nominal (money) discount rate of 10% per year and a target return on capital employed of 30% per year. Ignore taxation. Required: (a) Calculate the following values for the investment proposal: (i) net present value; (5 marks) (ii) internal rate of return; and (3 marks) (iii) return on capital employed (accounting rate of return) based on average investment. (3 marks) (b) Briefly discuss your findings in each section of (a) above and advise whether the investment proposal is financially acceptable. (4 marks) (c) Discuss how the objectives of PV Co's stakeholders may be in conflict if the project is undertaken. (5 marks) (20 marks)The following scenario relates to questions 26-30 Ridag Co operates in an industry which has recently been deregulated as the government seeks to increase competition in the industry. Ridag Co plans to replace an existing machine and must choose between two machines. Machine 1 has an initial cost of $200,000 and will have a scrap value of $25,000 after four years. Machine 2 has an initial cost of $225,000 and will have a scrap value of $50,000 after three years. Annual maintenance costs of the two machines are as follows: Year 2 3 Machine 1 ($ per year) 25,000 29,000 32,000 35,000 Machine 2 ($ per year) 15,000 20,000 25,000 Where relevant, all information relating to this project has already been adjusted to include expected future inflation. Taxation and tax allowable depreciation must be ignored in relation to Machine 1 and Machine 2. Ridag Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-tax weighted average cost of capital of 7%. 26 In relation to Ridag Co, which of the following statements about competition and deregulation are true? (1) Increased competition should encourage Ridag Co to reduce costs (2) Deregulation will lead to an increase in administrative and compliance costs for Ridag Co (3) Deregulation should mean an increase in economies of scale for Ridag Co (4) Deregulation could lead to a decrease in the quality of Ridag Co's products A 1 and 4 B 2 and 3 C 1 and 3 2 and 4 27 What is the equivalent annual cost of Machine 1? $90,412 $68,646 $83,388 $70,609 28 Which of the following statements about Ridag Co using the equivalent annual cost method are true? (1) Ridag Co cannot use the equivalent annual cost method to compare Machine 1 and Machine 2 because they have different useful lives (2) The machine which has the lowest total present value of costs should be selected by Ridag Co A 1 only Both 1 and 2 C 2 only D Neither 1 nor 229 Doubt has been cast over the accuracy of the year 2 and year 3 maintenance costs for Machine 2. On further Investigation it was found that the following potential cash flows are now predicted: Year Cash flow Probability ($) 18,000 0-3 N N 25,000 0-7 23,000 0-2 24,000 0-35 30,000 0-45 What is the expected present value of the maintenance costs for year 3? $26,500 $18,868 $21,624 $35,173 30 Ridag Co is appraising a different project, with a positive NPV. It is concerned about the risk and uncertainty associated with this other project. Which of the following statements about risk, uncertainty and the project is true? Sensitivity analysis takes into account the interrelationship between project variables Probability analysis can be used to assess the uncertainty associated with the project Uncertainty can be said to increase with project life, while risk increases with the variability of returns A discount rate of 5% could be used to lessen the effect of later cash flows on the decision (30 marks)