Question 1 A manufacturer of computers buys a specific part at a price of per hundred and uses 2 million parts per year. Management believe that it may be better for the firm to make the parts rather than outsource them. Direct production costs are estimated at .40 per unit and current plant overheads are equal to .10 per unit. The equipment required to manufacture the part would cost 0,000 and can be depreciated straight-line for tax purposes over five years to a zero book value. Management estimate that the equipment should last for 15 years provided it is overhauled every five years at a cost of 0,000 each time. The operation will require an incremental investment in current assets of 5,000. The company tax rate is 30% and taxes are paid as soon as any tax liability is incurred. The required return is 15% after-tax and there is no inflation. Required (a) Suppose the equipment overhaul is treated as a tax-deductible expense in the period in which it is incurred. Should the proposal proceed? (b) Does your answer to (b) change if each equipment overhaul is amortised over the following five years? Explain. (c) Suppose an investment of 0,000 per year in tax-deductible overheads results in direct costs falling to .34 per unit. Should the proposal proceed? (Assume each equipment overhaul is treated as an expense in the period in which it is incurred). Question 2 You have decided that it is time to start your own business. You are interested in running short courses in financial management, and your investigations reveal that there are 20,000 individuals per year doing short three-day courses in this area. This figure has remained constant over recent years and is expected to remain unchanged over the next five years. Demand for these courses has been stimulated by government incentives to firms who send their employees on these courses. There are currently three main providers in the area, and prices for courses are equal across providers at ,000. You decide that the best way to break into the market is to compete on price because your competitors are bureaucratic universities who tend to respond slowly to market developments. With this in mind, you decide to set your price for a three-day course at ,800 and expect to hold this price constant for the first three years. You do not expect the universities to match your price until year three. lower price should enable you to grab market share of 20% in the first year, and this will increase to 40% in the second year. Market share will drop back to 25% in year three following price-matching by your competitors. Further, you envisage that by reducing your price to ,500 per course in years four and five, you will be able to increase your market share to 28% in each of these years. You believe that in five years time there will be a change in government and the incentives provided to firms to send employees on financial management will end. As a consequence, your investment horizon is five years and you do not expect to be able to sell your business as a going-concern at that time. Your business will require an initial investment in equipment and facilities of million. Current regulations require you to depreciate this investment at a straight-line rate over ten years. You expect that you will be able to sell the equipment and facilities in five years for million. The business will require working capital equal to 25% of revenues, and all incremental investments in working capital over the life of the venture will be recovered at the end of five years. While revenues are recognised in your modelling at the end of each year, your investment in working capital for each year should be recognised at the beginning of each year. You estimate that variable costs will be ,000 per course participant, and fixed cash expenses (course lecturer fees and marketing expenses) will amount to .8 million per year. All revenue and expenses should be recognised at the end of the period in which they occur. The relevant tax rate is 30%, taxes are paid as soon as any tax liability is incurred, and inflation is expected to be zero. You require 15% return on your venture (after company taxes have been paid). Required (a) What is the net present value of the proposed venture? Should you proceed? (b) Your proposal hinges upon you competing on price. What is the net present value of the proposal if rather than cutting your price in years four and five you hold your price constant at ,800, with the result that your market share drops to 25% in each of these years? (c) Suppose your original proposal holds (as per (a)), but consultation with a recent graduate of one of these programs reveals that the business could proceed with a lower level of working capital without impacting adversely on the business. What is the impact on the proposal if working capital is instead equal to 15% of revenues? 1 and administrators to agree on a meeting time to review their pricing policies. Question 3 Logan Limited is planning to introduce a new product. The firm expects to sell 1,000 units of the product each year and the expected life of the product is five years. In order to manufacture the product, Logan will need to invest million up-front in equipment. The firm will also need to invest 0,000 in working capital at the beginning of the investment and this is expected to remain constant over the life of the product. The equipment can be depreciated straight-line to a zero book value over five years, and the expected salvage value is 0,000. Direct costs of manufacture will be 0 per unit, and fixed cash expenses will be million per year. The company tax rate is 30% and taxes are paid as soon as any tax liability is incurred. All applicable information is expressed in real terms. Required (a) If the required real rate of return is 10% and inflation is expected to be zero, what is the minimum price that can be set for the product? (b) What is the minimum price that needs to be set for the product if the required real rate of return is10% and inflation is expected to be 5% per annum? Assume you are setting the price as part of a contract that requires the price be fixed over the five year life of the product. (c) Assume inflation is 5% per annum and the price for the product in year one is set at ,200 per unit. At what percentage rate will you need to increase the price each year to ensure the firm earns the minimum required rate of return? Question 4 Forrester Creations are considering investing in one of two alternative projects. Both projects require an outlay of million, have a life of five years and can be depreciated on a straightline basis to a zero book value. Project A will generate revenue of million per year and incur cash expenses of million per year. The project will require supporting working capital equal to 20% of revenues and any investment in working capital each year occurs at the beginning of the period in question. The required rate of return for Project A is 12% aftertax. Project B will generate revenue of million in year one and this will decline by million per year. Cash expenses will be million per year. The project will require supporting working capital equal to 30% of revenues. The required rate of return for Project B is 14% after-tax. The company tax rate is 30% and taxes are paid as soon as any tax liability is incurred. Inflation is expected to be zero and the firm is generating profits from other sources. Required (a) Calculate the NPV average accounting rate of return for each project. Which project would you select based on each of these criteria? (b) Calculate the IRR and modified internal rate of return for the projects, where for the latter it is assumed that cash flows are reinvested at an annual rate of 12% per annum. Which project would you select according to the IRR criteria? Discuss.
1 Your
You know, from experience, that it will be at least one year before the universities can get academics
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