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Polly Co is keen to use discounted cash flow analysis as its project appraisal tool. The
following information about the company is available:
Share price $3.10
Share capital $3m
Nominal value of each share 50c
Market value of 9% irredeemable debentures $110
Total par value of the 9% irredeemable debentures $10m
The company has recently paid a dividend of $0.22. Five years ago, the dividend paid
was $0.18. The corporate rate of tax is 30% and is paid one year in arrears.
The first project the company wishes to consider involves spending $450,000
immediately on a one off advertising campaign to revitalise an old product. The
product has a remaining life of only 5 years.
This additional advertising expenditure is expected to raise annual sales by 10,000
units initially. This increase will then fall by 2,000 units per year.
The contribution per unit is expected to remain stable at $20 in real terms. General
inflation is currently 2.15%.
ACCA F9: FINANCIAL MANAGEMENT
8 KAPLAN PUBLISHING
Required:
(a) Calculate the weighted average cost of capital of Polly Co. (6 marks)
(b) Discuss the limitations of the WACC calculated. (5 marks)
(c) Evaluate the proposed advertising expenditure by calculating a net present
value using a real cost of capital. (7 marks)
(d) Explain the limitations of the net present value calculated and consider what
other factors the company should take into account when considering the
proposed expenditure. (7 marks)how do we treat the tax savings in this case? this is because in the solution the tax is saved as a lump sum in year 2 and i do not understand how that was arrived at as the question specified that the tax is payable one year in arrears
I assume that you are talking about the tax saving on the initial advertising campaign?
If we assume that the advertising occurs at the beginning of the first year (time 0) then it will only be at the end of the year that the taxable profits, and therefore the tax, is calculated. It is then another year before tax on these profits is payable.
So…..it is one year to the end of the first year, and then another year until the tax effect. This makes it two years before the tax saving. (OK is is two years less one day, but when we are discounting we are not worried about 1 days interest :-)) )
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