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Hi there,
Please can you help me work out where I have gone wrong:
Q.
NCW Co is considering acquiring the ordinary share capital of CEW Co. CEW Co has for years generated an annual cash inflow of $10m. For a one-off investment of $6m in new machinery, earnings for CEW Co can be increased by $2m per annum.
NCW Co has a cost of capital of 10%
What is the value of CEW Co?
$114m
$120m
$100m
$94mMy answer:
$10m x (1/0.1) = $100m
Less, $6m x 1.1 = ($6.6m)
Plus, £2m x (1/0.1) = £20m
My answer = £113.4mI selected £114m due to it being the closest figure.
Textbook Answer:
Should NCW Co purchase CEW Co it will acquire a cash flow of ($10 + 2) = $12m per annum, assuming that CEW Co invests the $6m in new machinery (Note, it should do this at its net present value = $2m/0.1 – $6m = $14m)
Therefore the value would be $12m/0.1 – $6m = $114m. Note the $12m is a perpetuity.
Why am I wrong to apply the cost of capital at 10% to the $6m investment?
We always assume that the initial investment is immediate i.e. at time 0, and that the recipes start in 1 years time (unless told differently).
The present value of the initial investment is the same as the investment – a flow at time 0 is not discounted.
I do suggest that you watch my free lectures on this (and the relevant Paper MA (was F2) lectures if needed, because this is a very basic Paper MA question).
The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
You’re right and don’t I feel dozy now. It is obvious and it seems that I had brain fog having spent all day studying.
Thanks John!
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