Question 1

ERS Ltd is considering the launch of a new product after an extensive market research whose costs were K20,000. The research cost is due for payment in a months' time. Based on the research findings, as well as internal management accounting information relating to costs, the assistant accountant prepared the following forecasts for the product.

Year 123 4

K K K K

Sales 180,000 200,000160,000120,000

Cost of sales. (115,000) (140,000)(110,000)(85,000)

Variable overheads. (27,000)(30,000)(24,000)(18,000)

Fixed overheads. (25,000)(25,000)(25,000)(25,000)

Market research cost expensed.(20,000)

Net profit/(loss). (7,000) 5,000 1,000 (8,000)

The CEO pointed out that the product achieved profits in only two years of its four-year life and that over the four-year period as a whole, a net loss was expected. However, before a meeting that had been arranged to decide formally the future of the product, the following additional information became available:

The new product will require the use of an existing machine. This machine was acquired some time back for K400,000 and has since been depreciated down value to a book value of K80,000. The machine can be sold for K70,000 immediately if the new product is not launched. If the product is launched, it will be sold at the end of the four-year period for K10,0

Additional working capital of K30,000 will be required immediately and will be needed over the fouryear period. It will be released at the end of the period.

The fixed overheads include a figure of K15,000 per year for depreciation of the machine and K5,000 per year for the re-allocation of existing overheads of the business. The company has a cost of capital of 10%. Ignore taxation.

Required:

a)Identify the relevant cash flows associated with the decision to launch the product and determine the net cash flows for years 1 to 4.

b)Calculate the Net present value (NPV) and the approximate internal rate of return(IRR) of the product and comment (with reasons) whether or not the product should be launched.

c)Outline the strengths the NPV over the IRR method as a basis for investment appraisal.

d)Briefly discuss how the firm's investment decision influence its financing decisions.[Total 35 marks]

Question 2

MM Co capital structure is as follows;

Km

Equity shares 125

Retained earnings150

Loan capital100

375

Over the past four years, the company has generated the following after-tax profits which have all been paid out as dividend based on the current dividend policy of 100 per cent pay-out.

After-tax profits or total dividends for the year ended 30 June

Year 2015 2016 20172018

Profits or Dividends (Km) 397429463500

The directors of MM Co is currently considering whether to recalculate the company's cost of capital. When evaluating investment decisions, the board uses the net present value method and uses a cost of capital of 18%. This figure, however, was calculated four years ago and since then the company has undergone various changes. The following information is also available:

The loan capital consists of 8% bonds that are redeemable in three years' time. The current market value of the bonds is K95 per K100 nominal value. The loan capital will be redeemed at its nominal value in three years' time.

The company has 25 million equity shares in issue and these shares are currently trading at K6.08 per share.

Recently, the directors decided to maintain the current capital structure of the company for the foreseeable future. Assume a tax rate of 35%.

Required:

a)Calculate, for MM Co, each of the following:

i.the cost of loan capital;

ii.the cost of equity capital; and,

iii.the weighted average cost of capital based on both book values and market values.

Briefly state why it is important for a company to carefully calculate its cost of capital