Question 1

Curechem SA Limited is a large publicly traded firm on the Johannesburg Stock Exchange. Based on a $100 000 market feasibility study it is considering the manufacture and sale of a new line of products developed by its R&D research group at a cost of $ 250,000. The finance department has gathered the following information on the investment proposal:

Initial investment (straight line depreciation) $ 9 million

Scrap value (year 4; tax paid yr. 5) $ 600 000

Selling price (current price) $ 80/yr

Expected selling price inflation 4%/yr

Variable operating costs (current price) $ 35/unit

Fixed operating costs $ 450 000

Expected operating cost inflation 3%/yr

Market research estimates that demand for the product will be as follows:

Year: 1 2 3 4

Demand (Units): $50 000 $85 000 $100 000 $75 000

The company has a real return hurdle rate of 12%. Expected inflation over the project's lifespan is 2.5%. CureChem Limited pays income tax at 30% payable 1 year in arrears. The project would qualify for the tax offices "accelerated" capital cost allowance of 33.3% per year on a straight line basis.

Required:

1.1. Calculate the flowing values for the investment proposal:

i. Net present value

ii. Internal rate of return

1.2. Briefly discuss your findings and advise whether the proposal is financially attractive

1.3. Assuming that the stock market is semi-strong efficient, what will be the implication for the firm's stock price if CureChem goes ahead with the project?

Question 2

Navidale, a listed engineering company, manufactures large scale plant and machinery for industrial companies. Until ten years ago, Navidale Limited pursued a strategy of organic growth. Since then, it has followed an aggressive policy of acquiring smaller engineering companies, which it feels have developed new technologies and methods, which could be used in its manufacturing processes. However, it is estimated that only between 30% and 40% of the acquisitions made in the last ten years have successfully increased the company's shareholder value.

Navidale Limited is currently considering acquiring Lochinvar, an unlisted company, which has three departments. Department A manufactures machinery for industrial companies, Department B produces electrical goods for the retail market, and the smaller Department C operates in the construction industry. Upon acquisition, Department A will become part of Navidale, as it contains the new technologies which Navidale is seeking, but Departments B and C will be unbundled, with the assets attached to Department C sold and Department B being spun off into a new company called Ndege Co.

Given below are extracts of financial information for the two companies for the year ended 30 April 2014.

Navidale Co Lochinvar Co

$ million $ million

Sales revenue 7902 1246

Profit before depreciation, interest and tax (PBDIT) 2444 374

Interest 138 43

Depreciation 724 101

Pre-tax profit 1582 230

Non-current assets 7239 982

Current assets 1426 465

7% unsecured bond ----- 40.0

Other non-current and current liabilities 2124 202

Share capital (50 cents / share) 1900 200

Reserves 4641 645

Share of current and non-current assets and profit of Navidale Co's three departments:

Department A Department B Department C

Share of current and non-current assets 40% 40% 20%

Share of PBDIT and pre-tax profit 50% 40% 10%

Other information:

(i) It is estimated that for Department C, the realisable value of its non-current assets is 100% of their book value, but its current assets' realisable value is only 90% of their book value. The costs related to closing Department C are estimated to be $ 3 million.

(ii) The funds raised from the disposal of Department C will be used to pay off Lonchivar Co's other non-current and current liabilities.

(iii) The 7% unsecured bond will be taken over by Ndege Co. It can be assumed that the current market value of the bond is equal to its book value.

(iv) At present, around 10% of Department B's PBDIT come from sales made to Department C.

(v) Ndege Co's cost of capital is estimated to be 10%. It is estimated that in the first year of operation Ndege Co's free cash flows to firm will grow by 20%, and then by 52% annually thereafter.

(vi) The tax rate applicable to all the companies is 20%, and Ndege Co can claim 10% tax allowable depreciation on its non-current assets. It can be assumed that the amount of tax allowable depreciation is the same as the investment needed to maintain Ndege Co's operations.

(vii) Navidale Co's current share price is $ 3 per share and it is estimated that Lochinvar Co's price-to-earnings (PE) ratio is 25% higher than Navidale Co's PE ratio. After the acquisition, when Department A becomes part of Navidale Co, it is estimated that Navidale Co's PE ratio will increase by 15%.

(viii) It is estimated that the combined company's annual after-tax earnings will increase by $ 7 million due to the synergy benefits resulting from combining Navidale Co and Department A.

Required:

4.1 Discuss the possible reasons why Navidale Co may have switched its strategy of organic growth to one of growing by acquiring companies.

4.2. Discuss the possible actions Navidale Co could take to reduce the risk that the acquisition of Lochinvar Co fails to increase shareholder value.

4.3. Estimate, showing all relevant calculations, the maximum premium Navidale Co could pay to acquire Lonchivar Co, explaining the approach taken and any assumptions made.