Degnis Co. – June 16.

In theory, the market value of a share is the present value of future expected dividends discounted at the shareholders required rate of return.

The question is asking what the problems are with this in real life.

As the examiners answer states (and as I spend time explaining in my free lectures), the problems are as to how we determine what dividends shareholders are expecting in the future, and as to how we determine what rate of return shareholders are requiring.

You ask about part B of the question. There are no calculations in part B.

I am sorry – I was looking at the wrong question on the exam paper 🙁 🙁

But Kaplan have shown the workings!!!

You have calculated in part (a) that the cash flow ignoring TAD in year 4 is 2802 – 785 = $2,017,000.

Part (b) is asking what extra NPV there will be if they continue selling motorhomes after year 4, in perpetuity. So, forgetting TAD for the moment, we need the PV of receiving 2,017,000 per year from year 5 in perpetuity. As normal, we multiply by 1/0.11 for the perpetuity, and then multiply by the 4 year discount factor at 11% because the perpetuity is starting 4 years late (at time 5 instead of at time 1).

In addition however we need to calculate the PV of the extra TAD that will occur after year 4. Given that the TAD is straight line over 10 years, and that they have already had 4 years, we need the PV of $112,000 (as calculated in part (a)) per year for years 5 to 10 (a total of 6 years). To discount for years 4 to 10, we multiply by the 6 year annuity factor at 11%, and then multiply by the ordinary present value factor for 4 years at 11% because the annuity is starting 4 years late (at time 5 instead of at time 1).

If you are unsure about the discounting of the flows starting at time 5, then please do watch my free lectures (and if necessary the free Paper MA lectures on discounted cash flow as well, because the discounting is revision from Paper MA (was Paper F2))

Your method for the annuity is fine. The difference is only tiny and is due to the fact that the discount factors in the tables are rounded to 3 decimal places. It would still get full marks.

In part (a) the NPV is – 139, but this is only looking at producing for 4 years.

In part (b) it then says that production will continue from year 5 to infinity, and the sales will be 450 per year.

So they will get after tax cash flows (before capital allowances) of 2,017,000 per year, and will also get the benefit of the capital allowances (tax allowable depreciation) of 312,282 per year for the remaining 6 of the 10 years over which it is being depreciated.

So the new NPV is the NPV for the first 4 years (as already calculated in part (a)) plus the PV of these extra flows.

Have you read the sentence above the workings in the answer?

If the project lasts 4 years then the NPV is negative and so is not acceptable.

If the project lasts just one more year, then the PV of the 5th years flows is 2,219,000 x 0.593 = 1,262,497 and therefore the project would become acceptable.

You are welcome.