QUESTION 1 (60 MARKS) Forever Foods Ltd. ("Forever Foods") is a large and profitable company which processes and sells canned foods. In the past, Forever Foods have always outsourced the canning of their foods to an outside entity at a cost of R1.45 per can. A new canning plant has just been released on the market and the management of Forever Foods are keen to possibly acquire their own canning plant, rather than continue to use the service of an outside firm. The canning plant will cost R2.6 million and will qualify for a depreciation deduction of 40% of the cost in the first year and 20% of the cost in each of the following three years. The plant's useful life is expected to be 5 years. At the end of five years the plant is expected to have a residual value of R700 000 It is estimated that 730 000 cans will be processed every year for five years. If the plant is purchased, a maintenance contract will have to be taken out to service the plant each year at a cost of R86 000 per annum, while other expenditure, including depreciation, will amount to R1.25 per can. As an introductory special to the market, the manufacturer of the plant is offering two special financing options : 1. A loan repayable in five equal annual arrear instalments at 5.8%. 2. A lease with five annual rental payments of R535 000, payable annually in advance. The lease payments include maintenance. According to the lease contract, ownership of the asset will not pass to the lessee at the end of the lease. Assume an income tax rate of 28%. Forever Foods has a before-tax cost of debt of 11.23% and a weighted average cost of capital of 14%. 3 HEMN230-1-Jul-Dec2021-SA1-SUPP-ES-V2-01112020 REQUIRED 1.1) Perform a net present value (NPV) valuation to determine how much the 5.8% loan option will cost Forever Foods. Show all calculations. (44 marks) 1.2) Perform a net present value (NPV) valuation to determine how much the leas- ing option will cost Forever Foods Assume an income tax rate of 28%. Forever Foods has a before-tax cost of debt of 11.23% and a weighted average cost of capital of 14% 3 HEMN230-1-Jul-Dec2021-SA1-SUPP-ES-V2-01112020 REQUIRED 1.1) Perform a net present value (NPV) valuation to determine how much the 5.8% loan option will cost Forever Foods. Show all calculations. (44 marks) 1.2) Perform a net present value (NPV) valuation to determine how much the leas- ing option will cost Forever Foods. (15 marks) 1.3) Advise Forever Foods which financing option they should take. (1 mark) Round off to two decimals where required. Aligns to SAICA competencies: V-2.1 V-3.3 Analyses the entity's current financial situation and considers factors impacting on the future outlook of the entity Performs financial analysis, interprets the results, and draws conclusions as to the entity's present and fore- casted financial situation, including - cash flow analysis Identifies and evaluates sources of funds Describes the role, characteristics, advantages and disadvantages of various sources of financing, sug- gests which source of financing is most appropriate in the circumstances (e.g. debt, equity, leasing), taking the entity's financial strategies and objectives into ac- count Evaluates financing alternatives considering the con- sequences, relative costs and benefits, and implica- tions for operational and future financing decisions (including any tax implications) suitable for the entity based on its strategies, including leases bank loans and other debt instruments Develops a portion of a financial proposal or financing plan that is supported by well-reasoned assumptions and up-to-date information 4 HEMN230-1-Jul-Dec2021-SA1-SUPP-ES-V2-01112020
