Question 1- Investment Appraisal Techniques
Superior Tasty Soup (STS) Limited a fast food company is considering purchasing a new storage machine for £438,700. The company is expecting an annual cash inflow of £123,000 from the sale of its products and an annual cash outflow of £25,500 for each of the six years of the machine’s useful life. The annual cash outflows do not include annual depreciation charges for the machine. The machine is depreciated using 27% reducing method. The machine is expected to last for six years, with a residual value estimated to be at the rate of 15% of the original cost of the machine. The cost of capital for (STS) Limited is 13%.
You are required to:
(a) Calculate (to two decimal places) using the following investment appraisal techniques, and provide brief recommendations as to the economic feasibility of acquiring the machine:
The Payback Period.
The Accounting Rate of Return.
The Net Present Value.
iv. The Internal Rate of Return
(20 marks)
Alternatively, the financial director of (STS) Limited is proposing to use 40% the total capital outlay for the above investment to repurchase some of the equity capital and the remaining funds to pay for cash dividends. Ensuring the response draws upon relevant academic research within this highly topical area of financial management, critically evaluate the effects of this proposal on the company.(500 words)
(10 marks)
Critically evaluate the benefits and limitations of each of the differing investment appraisal techniques, ensuring the use of relevant academic literature. (1500words) (20 marks)
Question 2 – Mergers and Takeovers
The managing directors of Kings PLC are considering what value to place on Dragon PLC, a company that they are planning to take-over soon. Kings’ share price is currently £4.15 and the company’s earnings per share stand at 29p. Kings PLC weighted average cost of capital is 12%.
The board estimates that annual after-tax synergy benefits resulting from the takeover will be £5.25m, that Dragon’s distributable earnings will grow at an annual rate of 2.5%. That duplication will allow the sale of the £31m of assets, net of corporate tax (currently standing at 21%), in a year’s time.
Information relating to Firedrake PLC:
Financial Statement of Firedrake PLC
£m £m
Non-current assets 273
Current assets 56
Total assets
Equity 329
Ordinary Shares (£1) 147
Reserves 64
Total equity 211
7% bonds 72
Current liabilities 46
Total liabilities 329
Statement of Profit or Loss extracts
£m
Profit before interest and tax 64.0
Interest payments 6.5
Profit before tax 57.5
Taxation 15.1
Distributable earnings 42.4
Other financial market information:
Current ex-div share price £2.35
Latest dividend payment 14p
Past four years dividends payment 9p, 10.5p, 11p, 12p
Dragon’s equity beta 1.05
Market risk premium 6%
Given the above information calculate the value of Firedrake PLC using the following valuation methods:
Price/earnings ratio (10 marks)
Discounted cash flow method (10 marks)
Dividend valuation method (10 marks)
Drawing relevant academic literature on the mergers and takeovers, critically discuss the problems associated with using the above valuation techniques. Based on your opinion, which of
the above valuation techniques would you recommend with economic justifications to the board
of Kings PLC to pursue in this acquisition. (1200-1500 words) (20 marks)
