The board of directors of the Alpha Group Plc are considering two projects –X and Y for further investment. A forecast of the net after-tax cash flows of Project X and Project Y has been prepared as follows:
Year Project X Project Y
0 -200 -800
1 100 340
2 100 340
3 100 340
4 100 340
The board of directors are considering whether they have the resources to undertake both projects at the same time. They decide to use capital budgeting techniques in order to make appropriate decisions. The required rate of return for both projects is 10%.
(1) Calculate the net present value (NPV) and internal rate of return (IRR) for both projects. What is the discount rate at which the NPV of project X is zero?
(2) If the projects are not mutually exclusive, what decision should the board make and why?
(3) If the projects are mutually exclusive, what decision should the board make and why?
(4) Calculate the discount rate at which the NPV would be equal for both the projects. Comment on how this discount rate affects investment decisions.
(5) Discuss with an example how mutually exclusive projects with unequal lives are analysed for investment decisions.
(1) Guardian Group Plc has issued 24 million ordinary shares of £1 per share. The beta of the shares is calculated as 2.2. It has also issued £20 million of bonds at face value with five years remaining to maturity. These bonds carry 8% coupon with semi-annual payments and are priced to yield 13.65%. Further information about new issues is as follows:
(a) If Guardian Group issues up to £5 million of new bonds, the bonds will be priced at par and have a yield of 13.65%.
(b) If Guardian Group issues more than £5 million of new bonds, the yield on the entire issuance will be 16%.
(c) Guardian Group is able to issue ordinary shares at £1 per share. The current risk-free rate is 3% and expected market return is 10%.The marginal tax rate is 30%
What is the weighted average cost of capital of Guardian Group if it raises £15 million of new capital while maintaining the same debt to equity ratio?
(2) Ranbaxy Company is planning to borrow £15 million that it will use to repurchase shares. The financial controller has put together the following information:
Share price (at buyback) = £25
Shares outstanding (before buyback) = 20 million
Earnings per share (EPS) before buyback = £2.50
After-tax cost of borrowing = 8%
Planned buyback is 600,000 shares
What is the impact of the buyback on EPS?
Discuss any two reasons why a company may decide on share repurchases as opposed to paying dividends.
(3) The use of debt in the capital structure of a company increases leverage. Leverage can be effectively used to increase the returns available to the shareholders.
(a) Critically evaluate showing examples the use of debt financing and leverage in the capital structure of a company.
(b) Discuss the optimal capital structure as per the static trade-off theory.
VIP Chemical Industries is looking to set up a new plant and expand its operations. The company currently has an option to buy an existing building for £480,000, with the necessary equipments to operate the plant costing£320,000. The initial working capital investment is £240,000.The plant’s estimated economic life is four years. At the end of four years,the building is expected to have a market value of £300,000 and book value of £436,320. The equipment is expected to have market value of £80,000 and book value of £54,400.
The other available information is as follows:
Annual sales £1,600,000
Fixed costs (excluding depreciation) £200,000
Depreciation on building and equipment (Year 1 £70,240; Year 2 £114,880; Year 3 £73,280; Year 4 £50,880)
Variable costs 60% of sales
Marginal tax rate 40%
Cost of capital 12%
Assume that operating cash flows occur at the end of each year.The operations will begin immediately after the investment is made, and the first operating cash flows will happen exactly one year later.Evaluate whether the project should be accepted or not using the net present value (NPV) and internal rate of return (IRR).
Airline companies often engage in jet fuel hedging. The notes to the financial statements section of the annual report, generally provides additional information about the hedging activities of a company. Obtain the most recent annual report of an airline company which hedges its jet fuel requirements.
Prepare a report to evaluate the instruments used to mitigate the risk of rising fuel costs, and discuss the impact of jet fuel hedging on the financial statements of the airline company.