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I am studying corporate finance. i need help for following question below.
1. a) The management of firm A is considering starting a new project. The project requires an initial investment equal to £1,000,000. The risk of the project is identical to that of the firm’s current risky assets. The expected rate of return on the new project is 15% annually in perpetuity. The firm’s balance sheet (market values) prior to the announcement of the investment project is as follows:
Fixed assets £ 5,000,000 Equity £4,000,000
Cash £1,000,000 Debt £2,000,000
Total 6,000,000 Total 6,000,000
There are 100,000 shares outstanding. The beta of the firm’s stock is equal to 1.35; the beta of its debt is equal to 0.15. The risk-free rate is equal to 4%, and the expected market risk premium is 7%.
i) Calculate the beta and the expected return of the firm using the Capital Asset Pricing Model (CAPM).
ii) How reliable are the CAPM and the C-CAPM in enabling a firm to measure the cost of capital?
Duo Co needs to increase production capacity to meet increasing demand for an existing product, ‘Quago’, which is used in food processing. A new machine, with a useful life of four years and a maximum output of 600,000 kg of Quago per year, could be bought for $800,000, payable immediately. The scrap value of the machine after four years would be $30,000.
Forecast demand and production of Quago over the next four years is as follows:
Year 1 2 3 4
Demand (kg) 1·4 mill 1·5 mill 1·6 mill 1·7 millExisting production capacity for Quago is limited to one million kilograms per year and the new machine would only be used for demand additional to this.
The current selling price of Quago is $8·00 per kilogram and the variable cost of materials is $5·00 per kilogram. Other variable costs of production are $1·90 per kilogram. Fixed costs of production associated with the new machine would be $240,000 in the first year of production, increasing by $20,000 per year in each subsequent year of operation.
Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances (tax-allowable depreciation) on a 25% reducing balance basis. A balancing allowance is claimed in the final year of operation.
Duo Co uses a cost of capital of 10% to appraise investments of this nature.
Required:
(a) Calculate the net present value of buying the new machine and advise on the acceptability of the proposed purchase
(13 marks)
(b) Calculate the internal rate of return (IRR) of buying the new machine and advise on the acceptability of the proposed purchase
(6 marks)
(c) Calculate the accounting rate of return (ARR) of the new investment and comment on the decision making process with respect to ARR.
(6 marks)
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