Question 1

One of your clients, Southgate plc., has asked for your assistance with its capital investment plans for the current financial year and the finance director has provided you with the following information:

Company details

The company has 50 million ordinary shares in issue which are currently trading at 620p c.u.m the recently declared final dividend of 20p. The beta value of the shares is 0.9, the proxy for the risk free rate is 1% and the proxy for the expected return on the market portfolio is 8%.

The company also has 100 million of 5% bonds in issue which are currently trading at 114.50 c.u.m-interest per 100 nominal. The last annual interest payment was made 6 months ago and they are redeemable at par in exactly 9 years.

The companys marginal rate of corporation tax is 20% and payments and rebates are subject to a one year delay.

Capital investment project details

The companys internal resources available for capital expenditure in the current financial year are 250,000 and the directors are considering the following two expansion projects which are independent and divisible:

Project name	Aston	Villa
Initial investment	200,000	150,000
Forecast annual profits	12,000	29,000
Estimated project life	5 years	6 years

The forecast annual profit figures are stated in pre-tax money terms inclusive of interest (calculated at 4% of the initial investment) and depreciation (calculated on the straight line basis to an anticipated nil residual value). Neither project qualifies for capital allowances.

Required:

1. Estimate the weighted average cost of capital of the company and explain whether this can be used as the discount rate to appraise the expansion projects.

(14 marks)

2. Calculate the net present value and profitability index of both of the expansion projects and advise the finance director on the optimal amount to invest in each.

(16 marks)

3. One of the directors has queried your use of the net present value method of investment appraisal and has stated that the accounting rate of return is a much better method which is easier to understand. Provide a balanced response to this directors assertion.

(10 marks)

(Total 40 marks)