You are the chief accountant of Moharamka Plc., which manufactures a wide range of building and plumbing fittings. It has recently taken over a smaller unquoted competitor, Moharam Ltd. Moharamka is currently checking through various documents at Moharams head office, including a number of investment appraisals. One of these, a recently rejected application involving an outlay on equipment of 900,000, is reproduced below. It was rejected because it failed to offer Moharams target return on investment of 25 per cent (average profit-to-initial investment outlay). Closer inspection reveals several errors in the appraisal. Evaluation of profitability of proposed project NT17 (all values in current year prices) 0 1 2 3 4 000 000 000 000 000 Sales 1,400 1,600 1,800 1,000 Materials (400) (450) (500) (250) Direct labour (400) (450) (500) (250) Overheads (100) (100) (100) (100) Interest (120) (120) (120) (120) Depreciation (225) (225) (225) (225) Profit pre-tax 155 255 355 55 Tax at 33% (51) (84) (117) (18) Post-tax profit 104 171 238 37 Outlay Stock (100) Equipment (900) Market research (200) (1,200) Rate of return = Average profit = 138 = 11.5% Investment 1,200 You discover the following further details: 1. Moharams policy was to finance both working capital and fixed investment by a bank overdraft. A 12 per cent interest rate applied at the time of the evaluation. 2. A 25 per cent writing-down allowance (WDA) on a reducing balance basis is offered for new investment. Moharams profit are sufficient to utilise fully this allowance throughout the project. 3. Corporation tax is paid a year in arrears. 4. Of the overhead charge, about half reflects absorption of existing overhead cost. 5. The market research was actually undertaken to investigate two proposals, the other project also having been rejected. The total bill for all this research has already been paid. 6. Moharamka itself requires a normal return on new projects of 20 per cent after taxes, is currently ungeared and has no plans to use any debt finance in the future. Required a) Identify and explain the mistakes made in Moharams evaluation. (500 words) b) Restate the investment appraisal in terms of the post-tax net present value to Moharamka, recommending whether the project should be undertaken or not. (500 words) Question 2 Is there any relationship between the level of free cash flow and the extent of agency conflict between shareholders and management? Explain (1000 words)