Final Test Assessment Criteria

Systematic Risk and the equity Risk Premium

 Understand what influences the volatility of a portfolio.

 Be able to understand the correlation coefficient and its use in portfolio construction.
 Understand the concept of diversification and what it achieves.
 Understand the concept of Beta and how it is utilised in the CAPM.
 Use the CAPM equation to relate risk to expected return.

Capital Budgeting

 Calculate NPV using various types of cash flows (annuity, deferred annuity).
 Understand the implication of NPV for decision making.
 Be able to depreciate an asset using the straight line method.
 Understand the tax implications of Depreciation (tax deductible expense).
 Be able to calculate the gain or loss on a sale of an asset and tax implications that follow.
 Calculate the initial outlay, on-going cash flows and terminal cash flows for a proposed
investment.
 Understand the implications of fixed overhead expenses, sunk costs, cannibalisation and
opportunity costs in investment decision making.
 Understand the concepts of Payback period, internal rate of return and profitability index.
 The limitations of the payback period.
 Make investment decisions when resources are limited.

Cost of Capital

 Explain the drivers of the firm’s overall cost of capital.

 Measure the cost of debt, preference shares and ordinary shares.
 Compute a firm’s overall cost of capital.
 Explain the assumptions relating to the use of a firm’s cost of capital.
 Adjust the cost of capital for the risk associated with a specific project.
 Account for the direct costs of raising external capital.

Leverage Analysis

 Understand and distinguish between business and financial risk.

 Be able to use break-even analysis
 Calculate and interpret measures of operating leverage, financial leverage and combined
leverage.
 Understand and use EBIT-EPS analysis to determine the point (EBIT) of indifference between
2 financing proposals.

Capital Structure

 Understand capital structure decisions in perfect capital markets with reference to the MM
proposition.
 Demonstrate and explain how debt can affect firm value through taxes.
 Demonstrate and explain how debt can effect firm value through both direct and indirect
bankruptcy costs.
 Explain how the optimal mix of debt and equity trades off the costs ( financial distress
costs) and benefits of debt (tax savings).
Problem 1

Your firm currently has $100 million in permanent debt outstanding with a 6% interest rate. Suppose
the marginal corporate tax rate is 30%, and that the interest tax shields have the same risk as the loan.
What is the present value of the Tax Shield?

Problem 2

You are considering an investment in a new capital asset. This new asset will require an initial
investment of $5,000,000. This asset will be depreciated straight line over ten years. If your firm’s
marginal tax rate is 30%, what is the value of the depreciation tax shield per year? Now assume you
sell this asset after 5 years and receive $2,000,000. Calculate any profit or loss associated with the sale
and the amount of tax payable or tax saving.
Problem 3

Compute the cost for the following sources of financing based on the following data:

1. A bond has a $1000 par value (face value) and a contract or coupon interest rate of
10%, paid annually with a $1045 market value. The bonds mature in 10 years. Estimate
the after-tax cost of bonds if the company tax rate is 30%. The firm has issued 1,000
bonds in total.
2. A company's ordinary shares paid a 50 cent dividend last year. Dividend per share has
grown at a rate of 8% per year. This growth rate is expected to continue into the
foreseeable future. The company. The price of this share is now $5.50. The company
has issued 500,000 shares
3. Preference shares are paying a 9% dividend on a $10.00 par value and have a current
market price of $13. The company has issued 50,000 preference shares.
4. Calculate the market values of debt, equity and preference shares and the WACC.
Problem 4

One year ago, your company purchased a machine used in its manufacturing operations for
$2,200,000. You have just recently discovered that a newly developed machine is now
available that offers a number of technological advantages when compared to the existing
machine. This new machine can be purchased for $3,000,000. It can be depreciated on a
straight-line basis over 10 years. It is not expected to have any salvage value, but it estimated
that $200,000 will be required in clean-up and disposal costs at the end of the 10 years. The
new machine will also require an initial increase in working capital of $150,000 which will be
recovered in year 10. You also expect that the new machine will produce a gross margin
(revenue minus expenses other than depreciation) of $500,000 per year for the next 10 years.
The current machine is expected to produce a gross margin of $200,000 per year. The current
machine is being depreciated on a straight-line basis over a useful life of 11 years, and has no
salvage value. The existing machine could be sold now for $1,500,000. Your company’s tax
rate is 30%, and the cost of capital for this type of investment is 10%.

Required:

1. Calculate the initial cash outlay for replacing the existing machine with the new machine.

2. Calculate the incremental on-going free cash flows relating to the replacement.

3. Calculate the terminal cash flows relating to the new project.

4. What does the NPV rule say you should do? (Calculate the NPV and interpret your
answer).
Problem 5

A sports manufacturing business is deciding whether to proceed with a corporate acquisition

of a competing business for the amount of $50,000,000. The acquisition of this business is
expected to generate additional cash flows of $8,000,000 per year for the next 10 year. If the
required rate of return is 10%, what will be the change in the value of the company if it
chooses to go ahead with the acquisition?

Problem 6

Your business has just invested $1,000,000 in a new crop. The crops are expected to take 2-
years to mature and will yield ripe crops from year 3. It is then expected to produce additional
crops every year for a total of 10 years. You expect to receive $200,000 each year from the
sale of these crops. If you require a return of 8% on this investment, what is the NPV of this
investment? Explain giving reasons why you would accept or reject this investment.
Solution 1:

PV of the tax shield $100m x 0.30 = $30million.

Now assume that the loan is only for a 10 year period. What is the PV of the tax shield under
this scenario?

Annual interest = $100 million x 6% = $6 million

Annual tax shield = $6 million x 0.30 = $1.8 million

PV of tax shield = $1.8 million x PVIFA n=10, i-6%

PV of tax shield = $1.8 million x 7.36 = $13.25 million

Solution 2:

Depn per annum = $5,000,000/10 = $500,000

Depn tax shield = $500,000 x 30% = $150,000

Sale of asset

Book value after 5 years $5,000,000 - $2,500,000 = $2,500,000

Gain/Loss = $2,000,000 (sale price) - $2,500,000 (Accum Depn)

Loss = $500,000

Tax Saving = $500,000 x 0.30 = $150,000

Solution 3:

Cost of debt

Part (1)

$100 + [(1000-1045)/10] / (1000+1045)/2

$95.50/1022.5 = 0.093 or 9.3%

After tax = 9.3(1-0.3) = 6.5%

Part (2)

Cost of equity – Using dividend growth model

0.50(1+0.08)/5.50 + 0.08

0.54/5.50 + 0.08

0.098 + 0.08 = 0.178 or 17.8%

Part (3)

Cost of preference shares (before tax)

0.90/13.00 = 0.90/13.00 = 0.069 or 6.9%

Dividend = 9% x $10 = $0.90

Part (4)

Market values

Bonds: = 1,000 x 1,045 = $1,045,000

Ordinary shares: = 500,000 x $5.50 = $2,750,000

Preference shares: = 50,000 x 13 = $650,000

Weightings

Bonds = $1,045,000/$4,445,000 = 23.5%

Ordinary shares = $2,750,000/$4,445,000 = 62%

Preference shares = $650,000/$4,445,000 = 14.5%

WACC = 6.5%(23.5%) + 17.8%(62%) + 6.9%(14.5%)

WACC = 13.5%
Solution 4:

Initial investment:
Installed cost of new asset =
Cost of the new machine -$3,000,000
+ Installation costs 0
Total cost of new machine $3,000,000
less After-tax proceeds from sale of old asset =
Proceeds from sale of existing machine +1,500,000
- Tax Saving* +150,000
Total after-tax proceeds from sale +1,650,000
plus Increase in net working capital -150,000
Initial investment $1,500,000

* Book value old machine = $2,200,000-$200,000 = $2,000,000

$1,500,000 - $2,000,000 = $500,000 Loss
$500,000 ×0.30 = $150,000 tax saving

ii
Calculation of Operating Cash Flows

Years 1-10
Change in Gross Margin $300,000
less Change in $100,000
Depreciation
NPBT $200,000
less Tax (30%) $60,000
NPAT $140,000
plus Depreciation $100,000
Operating cash flow $240,000

Incremental Operating Cash Flows

Change in Gross margin ($500,000-$200,000) = $300,000
Change in Depreciation = $300,000-$200,000 = $100,000
Existing Depreciation = 2,200,000/11 = $200,000
Depreciation New Machine: 3,000,000/10 = $300,000

(iii)
Terminal cash flow:
Total proceeds-sale of new asset $0
Clean-up costs -$200,000
plus Change in net working capital +$150,000
Terminal cash flow -$50,000
iv. PV of future cash flows: $240,000 x PVIFA n=10, i=10% + -$50,000xPVIFn=10,i=10%
$240,000 x 6.145 = $1,474,800
-50,000 x 0.386 = -$19,300
$1,474,800 + -$19,300 = $1,455,500

NPV = PV of cash inflows – Initial investment

NPV = $1,455,500– $1,500,000
NPV = -$44,500

Since the NPV < 0 the new machine should be rejected.

Solution 5:

PV of annual additional cash flows:

$8,000,000/0.10[1 – 1/(1.10)^10] = $49,156,032 approx

NPV = $49,156,032 - $50,000,000 + -$843,968

Accepting this project will reduce the firm’s value by $843,968.

Solution 6:

FV2= $200,000/0.08[1 – 1/(1.08)^10] = $1,342,003 approx

PV = $1,342,003/(1.08)^2 = $1,150,551

NPV = $1,150,551 - $1,000,000 = +$150,551

Accept as the investment has a positive NPV. This suggests we are exceeding the required
return on this investment.
Further considerations:

 Under what assumptions to we calculate and apply the WACC when making
investment decisions? Assume constant business and financial risk and limited
effects in relation to leverage.
 What if these assumptions cannot be met?
 How do we treat issue costs relating to capital raising in project evaluation?

 What other methods can be used to evaluate future projects? What are their
advantages and disadvantages?
 Ensure that you always use incremental data. Look for changes in cash flow or
earnings when replacing one asset with another.
 How do you assess projects when resources are limited?
 How do sunk costs, fixed overheads and cannibalisation impact project cash flows?