Topic about Investment Appraisal and Real Options

Lavender Berhad (Lavender) is evaluating the feasibility of Project A, which is a new line of business
that is different from its existing business operations. The directors are pursuing a corporate strategy of
diversifying into a new line of business because its existing business is facing declining sales due to
substitute products introduced by the competitors.

Below are the detailed cash flow projections for Project A, with 4 years of useful life:

1. Fixed assets
[capital allowance is claimable
on a 25% reducing balance
basis]
Year 0: Cost of investment is RM25 million
Year 4: Disposal value is RM2 million

2. Working capital
Year 0: Initial investment required is RM3 million
Year 1: Investment required is increased to RM5 million
Year 2: Investment required is increased to RM6 million

3. Revenue
Year 1: RM5 million
Year 2: RM8 million
Year 3: RM15 million
Year 4: RM25 million

4. Operating costs
Year 1: RM2 million
Year 2: RM3 million
Year 3: RM5 million
Year 4: RM7 million

5. Corporate taxation rate 24% (payable in the same year when profit is earned)

6. Volatility of project cash flows RM0.2 million per annum

Lavender’s existing business equity beta is 0.95 and gearing ratio (debt:debt+equity) is 60%. A proxy for the new line of business has an equity beta of 1.08 and gearing ratio (debt:debt+equity) of 50%. Assume that the debt betas for both companies are zero. Corporate taxation rate is 24%. Lavender has
sufficient taxable profits to claim all the tax reliefs available. Lavender’s pre-tax cost of debt is 10%.

Risk-free securities are yielding 4% and the market risk premium is 8%, which are assumed to remain
constant for the foreseeable future.

Project A has the potential to be expanded into the export markets starting from the end of Year 3.
Preliminary appraisal estimated that the investment cost of RM20 million will generate a net present value of RM4 million (as at the end of Year 3). Cost of capital is 12% and the volatility of cash flows is 35%.

The Business Development Director has proposed two additional investment projects that are focused on improving the existing business operations in order to increase Lavender’s market share and profitability. However, the Chief Financial Officer (CFO) is facing capital constraints this year due to the overall gearing ratio target of 60% being imposed by the board. Therefore, only RM50 million in total financing will be raised in Year 0. It is anticipated that there will no longer be any capital
constraints from Year 1 onwards.

The following are details of the two additional investment projects, which are not divisible:

a) Project B – This is an investment into product development to upgrade the existing product in
order to compete more effectively against the substitute products introduced by the
competitors. Initial investment cost of RM15 million is required in Year 0 and it will generate a positive net present value of RM2 million over its 4 years of useful life.

b) Project C – This is an investment to automate the existing business operations in order to improve the productivity and reduce overhead costs so as to improve the profit margin. Initial
investment cost of RM20 million is required in Year 0 and it will generate a positive net present value of RM8 million over its 4 years of useful life.

The value of the option to expand Project A into the export markets should be added to Project A’s
existing net present value when comparing against Project B and Project C in order to make the capital
rationing decision. Project A is also not divisible.

Required:
The CFO has requested you, the Financial Analyst, to write a report to:
(a) Calculate the net present value (NPV) of Project A. (12 marks)

(b) Based on the figures in (a) above, calculate the following in respect of Project A:
• Modified Internal Rate of Return (MIRR); (3 marks)
• Macaulay duration; and (4 marks)
• Value at risk (VAR) at 95% confidence level. (3 marks)

(c) Interpret the results of all the calculations in (a) and (b) above. (4 marks)

(d) Calculate the value of the option to expand Project A into the export markets. Comment on the
result. (8 marks)

(e) Recommend (with reasons) an appropriate method of capital rationing decision in choosing
between Project A, Project B and Project C. Provide a conclusion. (6 marks)

(f) Advise on THREE (3) NON-FINANCIAL factors that should be considered before making
the final decision in choosing between Project A, Project B and Project C. (6 marks)

Professional marks will be awarded for format, style, structure and clarity of discussion. (4 marks)
[Total: 50 marks]