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Didcot plc is considering 2 potential new investments to enhance its manufacturing plant. These are mutually exclusive options in that the acceptance of any one investment would prevent investment in the other.
The organisation uses a net present value (NPV) approach to such decisions and uses its weighted average cost of capital (WACC) as the discount factor within the model.
Currently Didcot plc has 300,000 x £1 Ordinary shares and £200,000 of debt. The Ordinary Shareholders expect a yield of 17% and the after-tax cost of debt is 12%.
Details of the two investments in the plant enhancement are as follows:
Investment A has an immediate cash outflow of £50,000 and this would be followed by cash inflows of £20,000 at the end of year 1 and 2, £15,000 at the end of year 3 and 4.
Investment B requires no immediate cash outflow, but £5,000 per annum would be paid at the end of years 1, 2, 3 and 4. Cash inflows of £15,000 would also be received at the end of years 1, 2, 3 and 4.
Assume, for purposes of this case, that the annual cash inflows equate to taxable profits before capital allowances
For investment A, the initial outflow of £50,000 attracts a first year taxation capital allowance of 35% based on the initial investment amount, followed by writing down allowances of 35% of the tax written down value for years 2 and 3. As the investment will be disposed of at the end of year 4 with a nil residual value, the capital allowance to be claimed in year 4 will therefore be a balancing allowance which will reduce the taxation written down value to zero.
[For example if the initial investment had been £100,000, then capital allowances to be claimed would have been £35,000 in year 1, £22,750 for year 2, £14,788 for year 3 (tax written down value at this point = £100,000 - £72,538 = £27,462) and a balancing allowance of £27,462.]
The capital allowance in respect of Investment A is available for offset against taxable profits in each year.
For Investment B no capital allowances are available, but the annual outflows of £5,000 can be set against the £15,000 inflows for taxation purposes, making the taxable profits £10,000 per annum.
Didcot plc pays corporation tax at the rate of 25% of its taxable profits after allowing for capital allowances (where applicable). Assume that taxation in respect of year one profits is paid at the end of year two.
[So, for example if a project has taxable profits (before capital allowances) of, say, £40,000 in year 1 and if the company claims a capital allowance of £35,000, it would be charged corporation tax of 25% x (£40,000 - £35,000) = £1,250 for that year. The £1,250 tax would be paid in year 2.]
Requirements
a) Calculate the net present values of each of the proposed investments and recommend which of the two, if any, should be selected. Give detailed reasons for your recommendation. (35 marks in total)
Didcot plc is considering 2 potential new investments to enhance its manufacturing plant. These are mutually exclusive options in that the acceptance of any one investment would prevent investment in the other.
The organisation uses a net present value (NPV) approach to such decisions and uses its weighted average cost of capital (WACC) as the discount factor within the model.
Currently Didcot plc has 300,000 x £1 Ordinary shares and £200,000 of debt. The Ordinary Shareholders expect a yield of 17% and the after-tax cost of debt is 12%.
Details of the two investments in the plant enhancement are as follows:
Investment A has an immediate cash outflow of £50,000 and this would be followed by cash inflows of £20,000 at the end of year 1 and 2, £15,000 at the end of year 3 and 4.
Investment B requires no immediate cash outflow, but £5,000 per annum would be paid at the end of years 1, 2, 3 and 4. Cash inflows of £15,000 would also be received at the end of years 1, 2, 3 and 4.
Assume, for purposes of this case, that the annual cash inflows equate to taxable profits before capital allowances
For investment A, the initial outflow of £50,000 attracts a first year taxation capital allowance of 35% based on the initial investment amount, followed by writing down allowances of 35% of the tax written down value for years 2 and 3. As the investment will be disposed of at the end of year 4 with a nil residual value, the capital allowance to be claimed in year 4 will therefore be a balancing allowance which will reduce the taxation written down value to zero.
[For example if the initial investment had been £100,000, then capital allowances to be claimed would have been £35,000 in year 1, £22,750 for year 2, £14,788 for year 3 (tax written down value at this point = £100,000 - £72,538 = £27,462) and a balancing allowance of £27,462.]
The capital allowance in respect of Investment A is available for offset against taxable profits in each year.
For Investment B no capital allowances are available, but the annual outflows of £5,000 can be set against the £15,000 inflows for taxation purposes, making the taxable profits £10,000 per annum.
Didcot plc pays corporation tax at the rate of 25% of its taxable profits after allowing for capital allowances (where applicable). Assume that taxation in respect of year one profits is paid at the end of year two.
[So, for example if a project has taxable profits (before capital allowances) of, say, £40,000 in year 1 and if the company claims a capital allowance of £35,000, it would be charged corporation tax of 25% x (£40,000 - £35,000) = £1,250 for that year. The £1,250 tax would be paid in year 2.]
Requirements
a) Calculate the net present values of each of the proposed investments and recommend which of the two, if any, should be selected. Give detailed reasons for your recommendation. (35 marks in total)
