Sebastian Trains Co (ST) is a UK based rail operating company which holds three UK rail
franchises. The franchises allow ST to run trains on the rail network in a particular
geographical area within the UK. All three of the franchises have been profitable over the
last 2 years, and they are all up for renewal in 3 years’ time.
ST is a listed company in the UK, and its most recent accounts show an operating profit of
£58.9m on a turnover of £206.8m.
The directors are keen to diversify the company’s operations geographically, in order to
reduce their reliance on the UK market, and to try to avoid the potential problem of having
all franchises up for renewal at the same time. An opportunity has arisen for ST to apply for
a 5 year rail franchise in Germany, where the currency is the Euro (€). The current rate of
exchange for the € to £ is €1.2525 per £1.
If ST were to win the franchise, a fee of €10m would be payable immediately to the German
Rail Authority, followed by an annual fee of €5m (nominal cash flow) each year thereafter.
These amounts would not be tax deductible.
In order to satisfy the terms of the franchise, ST would have to purchase 2 new trains, at a
total cost of €26m, and to invest £6m immediately to renovate 2 other trains which have
been owned by ST for many years, but have been surplus to requirements in recent years.
Under the terms of the franchise, the € capital expenditure would qualify for a 50% first
year tax depreciation allowance in Germany. The balance of the € expenditure would be
claimed in equal instalments over the remaining 4 years of the franchise. The £ capital
expenditure would qualify for a 100% first year tax depreciation allowance in the UK.
Total passenger journey numbers are expected to be 1 million in the first year of the
German franchise, but it is thought that a nominal cash flow investment of €1.25m per
annum in marketing (starting in 1 year’s time) should help to create extra demand, leading
to a 5% per annum (compound) increase in passenger numbers over the term of the
franchise.
The average fare per passenger journey is currently €40, but the terms of the franchise
allow for this to be increased in line with German inflation over the term of the franchise.
Other costs associated with running trains for the German franchise are forecast to be:
• fixed costs of €10m (in current terms),
• variable costs per passenger journey, which amount to 25% of fares on average.
UK inflation is forecast to be 3.7% per annum and German inflation is forecast to be 2.2%
per annum. Both of these rates are expected to stay constant for the foreseeable future.
The UK tax rate is 28% and the German tax rate is 30%. In both cases, tax is paid at the end
of the period in which any profit is made. A double tax treaty exists, meaning that income
which has already been taxed in Germany is not liable to further tax after it has been
remitted to the UK.

ST appraises prospective franchise investment opportunities using the following procedure:
• the net present value method is used in the first place, based on the assumption that
all € denominated cash flows will be remitted back to the UK. The final NPV is
computed in £.
• as an alternative to NPV, the Modified Internal Rate of Return is also computed.
• all cash flows are assumed to arise at the end of the year concerned, except the
initial franchise payment and capital expenditure.
• the post-tax residual value of the 2 new trains at the end of the franchise is assumed
to be 20% of the initial cost, adjusted for local inflation. The two other trains being
renovated for the project would have no residual value.
• ST’s real cost of capital is 6.1%
Required:
(a) Prepare a schedule showing the nominal post tax cash flows projected for the
German franchise project, and calculate the project’s NPV in £. (13 marks)
(b) Calculate the project’s Modified Internal Rate of Return. (3 marks)
(c) Assess the likely viability of the project, taking into account the results of your
analysis in parts (a) and (b) above, and any other factors which you consider to be
important. (4 marks)
(d) Discuss the various funding options which might be available to ST for a project of
this type. (5 marks)