SECTION A: This is a compulsory question (Total 40 marks) Question 1 Somme plc (Somme) is considering an investment project which requires an initial investment in machinery of HK$40 million, payable at the start of the first year of operation. At the end of three years this machinery will be traded in for HK$3,000,000 and if demand for the product is still strong new machinery will be purchased. The initial HK$40 million investment will attract capital allowances at a rate of 20% per annum on a reducing balance basis. The rate of corporation tax is 25% per annum and any tax liabilities are paid in the year after they arise. Market research has been carried out at a cost of HK$500,000, to determine the selling price and the sales and production volumes that are likely to be achieved in the first three years of the project. These have been forecasted as follows: Year 2 Sales and production (units) 150,000 250,000 300,000 Selling price per unit at year zero values HK$250 HK$300 HK$350 1 3 These selling prices are expected to be subject to annual inflation of 4%. Based on the sales and production volumes above, the current value of production costs and overheads have been forecasted as follows: Year 1 2 3 Current Values at Year Zero Production costs HK$25,500,000 HK$42.500,000 HK$51,000,000 Total overhead costs HK$11,000,000 HK$11,000,000 HK$11,000,000 Total overhead costs include HK$ 9 million which are only incurred if the project goes ahead. 21 Production costs and incremental project overheads are expected to be subject to annual inflation of 5%. The project will require inventory of HK$1,000,000 to be purchased before the project becomes operational. This will be subject to inflation of 5% per annum and will be released at the end of the project. Somme use a nominal (money) after-tax discount rate of 11% per year to evaluate their capital investments. Required: SECTION B: Answer 3 questions from choice of 5 (Total: 60 marks) Question 2 The following information has been taken from the statement of financial position of Cos plc (Cos), a HK listed company: HK$ m Equity and Reserves Ordinary shares Reserves 15 29 44 6 50 6% preference shares 18 Non-current Liabilities 4% Redeemable Bonds Current Liabilities Trade and other creditors 12 80 Total Equity and liabilities The ordinary shares of Cos have a nominal value of HK$5 per share and a current market price of HK$31 per share. The 6% preference shares of Cos have a nominal value of HK$10 per share and a current market price of HK$12 per share. The bonds have a nominal value of HK$1000 and a current market price of HK$1035. They were issued seven years ago at a low coupon rate of 4% and are redeemable in three years' time at a 10% premium to the nominal value. The risk-free rate of return is 3.5% per annum and the equity risk premium is 6.8% per annum. Cos has an equity beta of 1.25. Cos pays corporation tax at a rate of 20% per annum. Required: a) Calculate the after-tax Weighted Average cost of Capital (WACC) of Cos. You must state all assumptions and show all workings (11 marks) b) From a theoretical basis discuss when it would be correct to use the WACC in appraising future projects. (5 marks) c) Describe the key features of any two of the sources of long-term finance used by Cos. (4 marks) (Total: 20 marks) SECTION A: This is a compulsory question (Total 40 marks) Question 1 Somme plc (Somme) is considering an investment project which requires an initial investment in machinery of HK$40 million, payable at the start of the first year of operation. At the end of three years this machinery will be traded in for HK$3,000,000 and if demand for the product is still strong new machinery will be purchased. The initial HK$40 million investment will attract capital allowances at a rate of 20% per annum on a reducing balance basis. The rate of corporation tax is 25% per annum and any tax liabilities are paid in the year after they arise. Market research has been carried out at a cost of HK$500,000, to determine the selling price and the sales and production volumes that are likely to be achieved in the first three years of the project. These have been forecasted as follows: Year 2 Sales and production (units) 150,000 250,000 300,000 Selling price per unit at year zero values HK$250 HK$300 HK$350 1 3 These selling prices are expected to be subject to annual inflation of 4%. Based on the sales and production volumes above, the current value of production costs and overheads have been forecasted as follows: Year 1 2 3 Current Values at Year Zero Production costs HK$25,500,000 HK$42.500,000 HK$51,000,000 Total overhead costs HK$11,000,000 HK$11,000,000 HK$11,000,000 Total overhead costs include HK$ 9 million which are only incurred if the project goes ahead. 21 Production costs and incremental project overheads are expected to be subject to annual inflation of 5%. The project will require inventory of HK$1,000,000 to be purchased before the project becomes operational. This will be subject to inflation of 5% per annum and will be released at the end of the project. Somme use a nominal (money) after-tax discount rate of 11% per year to evaluate their capital investments. Required: SECTION B: Answer 3 questions from choice of 5 (Total: 60 marks) Question 2 The following information has been taken from the statement of financial position of Cos plc (Cos), a HK listed company: HK$ m Equity and Reserves Ordinary shares Reserves 15 29 44 6 50 6% preference shares 18 Non-current Liabilities 4% Redeemable Bonds Current Liabilities Trade and other creditors 12 80 Total Equity and liabilities The ordinary shares of Cos have a nominal value of HK$5 per share and a current market price of HK$31 per share. The 6% preference shares of Cos have a nominal value of HK$10 per share and a current market price of HK$12 per share. The bonds have a nominal value of HK$1000 and a current market price of HK$1035. They were issued seven years ago at a low coupon rate of 4% and are redeemable in three years' time at a 10% premium to the nominal value. The risk-free rate of return is 3.5% per annum and the equity risk premium is 6.8% per annum. Cos has an equity beta of 1.25. Cos pays corporation tax at a rate of 20% per annum. Required: a) Calculate the after-tax Weighted Average cost of Capital (WACC) of Cos. You must state all assumptions and show all workings (11 marks) b) From a theoretical basis discuss when it would be correct to use the WACC in appraising future projects. (5 marks) c) Describe the key features of any two of the sources of long-term finance used by Cos. (4 marks) (Total: 20 marks)