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## Calculation of Taxable Income

Tastegood Limited is a public listed company that specializes in the production of confectionery.The production relies heavily on the use of machinery. The company has 215,000 number ofshares outstanding trading on the stock exchange.

Tastegood is currently in negotiation with a large supermarket chain, Cheap & Good Limited,to supply its confectionery in a private label for Cheap & Good. Under the terms, Tastegood isexpected to supply confectionery to Cheap & Good every year for the next ten years. If Tastegood proceeds with the supply of confectionery, the company needs to purchase machinery to cope with the increase in production. New machinery is expected to cost \$2,600,000,with an additional \$200,000 installation and shipping costs. The machinery is expected to havea working life of 10 years. The company’s accounting policy is to depreciate using the reducingbalance approach. For the new machinery, the company decides to use a depreciation rate of 20% per annum. It is expected that the new machinery can be sold for \$200,000 at the end of its useful life.

If Tastegood is to proceed with the supply of confectionery to Cheap & Good, it is expected that the yearly operating revenues would increase by \$800,000 in year one. From year two onwards, it is expected that the increase in yearly operating revenues would grow at a rate of 10% per annum. Total variable and fixed operating costs associated with increased production would be 40% of the increase in yearly operating revenues. However, as the private label confectionery’s selling price is cheaper than Tastegood’s brand, it is expected that Tastegood’s existing operating revenues would fall by \$200,000 per annum and existing operating costs would decrease by \$80,000 per annum if Tastegood proceeds with the supply of confectionery. Moreover, there would be an initial increase in net working capital of \$50,000. From year one to year nine, net working capital is expected to increase by \$10,000 per year. All the net working capital can be recovered at the end of the project’s life.

The company requires you to calculate an appropriate discount rate using the company’s weighted average cost of capital. The company’s capital structure has remained fairly stable, with a debt-to-equity ratio of 0.8. The company has no plan to adjust its capital structure in the future. Given that the company is listed on the stock exchange, you are able to obtain thehistorical returns over the last 20 years for the company, the market portfolio and the risk-free asset as tabulated in Table 1. The company debentures have a face value of \$1000 and a coupon rate of 12%. They mature in 5 years time. Similar debentures are currently yielding 15%. The company tax rate is 30%.
Table 1 Historical yearly returns for Tastegood, market and risk-free bond
Year Tastegood Market Risk-free
1998 5.64% 10.43% 5.49%
1999 23.13% 13.81% 6.01%
2000 19.55% 12.77% 6.31%
2001 10.08% 7.65% 5.62%
2002 -19.35% -10.64% 5.84%
2003 25.01% 14.61% 5.37%
2004 29.21% 29.48% 5.59%
2005 28.41% 23.83% 5.34%
2006 22.29% 20.93% 5.59%
2007 -5.68% 1.73% 5.99%
2008 -68.09% -33.58% 5.82%
2009 48.21% 33.84% 5.04%
2010 12.39% 8.03% 5.37%
2011 -6.54% -6.43% 4.88%
2012 15.28% 18.56% 3.38%
2013 -1.12% 10.38% 3.70%
2014 17.98% 11.67% 3.66%
2015 -15.44% -6.43% 2.71%
2016 26.23% 16.29% 2.34%
2017 0.20% 5.70% 2.72%
Furthermore, the CEO suggests conducting sensitivity analysis as follows because of uncertainty in relation to some of the expected cash flows:
1. Allow for a 30% probability that incremental revenues associated with the supply of private label confectionery would be 40% lower than expected starting from year six;
2. Allow for a 20% probability that incremental revenues associated with the supply of private label confectionery would be 20% higher than expected starting from year six.
Semi-strong form efficiency tests are concerned with whether security prices reflect all publicly available information. The event study methodology can be used to investigate the effects of many events such as a corporate announcement. By studying the stock price reaction before, during and after an announcement, an examination of whether the market is semi-strong form efficient can be conducted.

After performing the full analysis in Part 1, assume that Tastegood decides to proceed with the supply of private label confectionery to Cheap & Good. As such, the company announces details related to the expected increase in profits and cash flows that it would achieve from the supply of private label confectionery. The table below shows the daily returns of Tastegood (stock), the market and the risk-free asset 5 days before and after the announcement. Day 0 is the day of the announcement and there is no other price-sensitive announcement within the event window.

Calculation of Taxable Income

Being a public listed company Tastegood Limited have 215,000 numbers of outstanding shares and the company is specialized in the production of confectionary where the production is highly dependent upon the use of heavy machineries (Winfree et al, 2018). The business deal between Tastegood Limited and Cheap & Good Limited is for 10 years where confectionaries will be provided by the former to the latter. Thus there exists requirement of extensive production of goods and services that will be able to cope up with the high market demand of the confectionaries.

Tastegood Limited needs to invest much more in the machineries to raise their efficiency and fulfil the huge production targets (Zhang, Huang and Zhang, 2015). The depreciation is done through the reducing balance approach where a depreciation rate of 20 % is being used. The residual value of the machineries are \$ 200, 000 though at the time of purchase the total cost of the machineries is\$ 2, 600, 000 along with an additional pay of \$200, 000 for shipment and installation. At the initial year the operating Revenue is \$ 800, 000 while it will rise by 10 % per year (Malenko, 2016). The sum total of the fixed and variable cost of production is 40 % of the yearly rise in the operating revenue.  Notably the private level confectionary that will be sold by Cheap & Good Limited will be originally supplied for 10 years by Tastegood Limited and have a cheaper selling price than the Tastegood brand (Hong, Li and Xu, 2018). Hence the operating revenue of Tastegood will encounter a fall in its operating revenue by \$ 200, 000 every year and operating cost will decrease by \$80, 000 each year of their production. The net working capital will rise initially by \$50, 000 whereas per year the increase in working capital will be \$10, 000 which will get recovered after the completion of the project (Hamid et al., 2017). The debt to equity ratio is considered to be 0.8 and based on these information the discounting rate can be computed as follows:

 Year 0 1 2 3 4 5 6 7 8 9 10 STEP 1 - Calculate Taxable Income Operating Revenue 2800000 800, 000 880, 000 968, 000 1, 064, 800 1, 171, 280 1, 288, 408 1, 417, 249 1, 558, 974 2, 750, 000 3, 025, 000 Change in Revenue -200, 000 -200, 000 -200, 000 -200, 000 -200, 000 -200, 000 -200, 000 -200, 000 -200, 000 -200, 000 Change in Cost -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 Depreciation 2, 240, 000 1, 792, 000 1, 433, 600 1, 146, 880 917, 504 734, 003 587, 203 469, 762 375, 810 300, 648 Gain/Loss on Sale for new machine Taxable income 2, 760, 000 2, 392, 000 2, 121, 600 1, 931, 680 1, 808, 784 1, 742, 411 1, 724, 451 1, 748, 736 2, 845, 810 3, 045, 648 Tax @ 30% 0 -828000 -717600 -636480 -579504 -542635. 2 -522723. 36 -517335. 41 -524620. 72 -853742. 89 -913694. 31 STEP 2 - Include All Cash Flows Tax refund/paid 0 -828000 -717600 -636480 -579504 -542635. 2 -522723. 36 -517335. 41 -524620. 72 -853742. 89 -913694. 31 Initial Cost 2, 800, 000 Working Capital -50, 000 -60, 000 -70, 000 -80, 000 -90, 000 -100, 000 -110, 000 -120, 000 -130, 000 -140, 000 950, 000 Increased Revenue 600, 000 680, 000 768, 000 864, 800 971, 280 1, 088, 408 1, 217, 249 1, 358, 974 2, 550, 000 2, 825, 000 Increased Cost -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 -80, 000 Salvage value of machine 200000 Net Cash Flow 2, 750, 000 -368, 000 -187, 600 -28, 480 115, 296 248, 645 375, 685 499, 913 624, 353 1, 476, 257 2, 981, 306 PVCF @ 10% -306667 -155041 -21397 78749 154389 212064 256535 291265 626077 1149422 STEP 3 - Make Decision NPV 5, 007, 516. 95 IRR 41. 25% Payback Period 1. 15 Tax Rate 30%

With the objective to initiating a probabilistic change of 30 % in the incremental revenue in association with the supply of private label confectionaries by Taste Goods where there is 40 % lower revenue generation from the expected level starting from year six as well as where there is 20 % lower revenue generation from the expected level starting from year six with 20 % probability can be reflected through the following computations (Johnson and Pfeiffer, 2016).

 Market Assumptions Risk Free rate 2.72% Market Risk Premium 5.70% Equity Assumptions Beta 1 Cost of Equity 8% Market Value of Equity (Estimated) Rate 1.70 Debt Assumptions Pre-tax cost of debt 3.00% Effective Tax Rate 30% After Tax Cost of Debt 2.10% Market Value of Debt (Estimated) Firm's Assumptions Firm Value  (Estimated) Debt to Market Value Ratio WACC 9.34%
 No of Years Future Cash Flows 30 % probabilistic change 20 % probabilistic change Firm Value \$435,101,849.14 1 -368000 -368000 -368000 Debt Value \$193,378,599.62 2 -187600 -187600 -187600 Equity Value \$241,723,249.52 3 -28480 -28480 -28480 Shares Outstanding 215000 4 115296 115296 115296 Intrinsic Value/Share \$1,124.29 5 248644.8 248644.8 248644.8 Market Price/Share 6 375684.64 330602.4832 390712.0256 Debt to Equity Ratio 0.8 7 499913.392 439923.785 519909.9277 Maturity 5 8 624352.9616 549430.6062 649327.0801 Coupon Rate 12.00% 9 1476257.108 1299106.255 1535307.393 Face value \$1,000 10 2981305.687 2623549.004 3100557.914 Present Value -\$899.44 NPV \$2,398,224.88 \$2,077,376.13 \$2,505,174.46 YTM 15.00% Coupon PMT \$120

It is clearly been seen that based on the beat , market risk free rate and the incremental change it is better for Tastegood to allow for the deal where they will be selling their confectionary materials to Cheap & Good Limited (Atanasov, Pirinsky and Wang, 2018). The expectation of the target consumer base will be higher due to existence of greater demand into the market and it is been find that the present value is positive. Moreover, the future value of 1000 dollars of the debentures possess present value of 899.44 dollars.

## Determination of Discount Rate

Clearly, it is known that the expected return based on the CAPM model is dependent upon the market portfolio, risk free rate as well as the beta coefficient (Arthur, 2018). Depending upon these factors the computation of expected return of Tastegood Company can be executed. The beta coefficient of any investment reflects the extent up to which the investment varies depending upon the fluctuations that exists due to its uncertainty and asymmetric information within the market (Almazan, Chen and Titman, 2017). It is been found that the beta of this market is 1.561 and based on that the expected returns upon the individual stocks of Tastegood can be calculated. It is been found that the value of beta is high and this highlights the fact that the market is risker and hence is accompanied by higher amount of returns (Gay, 2016). The formula for expected return for Tastegood based on CAPM can be represented as follows:

) =  + E () -}

Based on the calculated value of Beta it is been found that the value is 1.561 of the market. It is been calculated based on the impact that the market risk rendered upon the individual stock of Tastegood over the years (Abor, 2017). The regression statistics for computation of beta can be represented as follows:

 Regression Statistics Multiple R 0.96230865 R Square 0.92603794 Adjusted R Square 0.92192894 Standard Error 0.06868207 Observations 20
 ANOVA df SS MS F Significance F Regression 1 1.063112 1.063112 225.368 1.27152E-11 Residual 18 0.08491 0.004717 Total 19 1.148022 Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept -0.05882512 0.018055 -3.25808 0.004367 -0.096757644 -0.02089 -0.09676 -0.02089 Beta 1.561 0.103965 15.01226 1.27E-11 1.342329854 1.779175 1.34233 1.779175

Based on the beta value the computation of expected return and from that the computation of abnormal returns can be done as follows:

 Day Stock Return Market Return Risk-free Expected Returns Abnormal Returns -5 0.300% 0.300% 0.0075% 0.464% -0.164% -4 0.450% 0.200% 0.0075% 0.308% 0.142% -3 -0.180% 0.010% 0.0075% 0.011% -0.191% -2 -0.600% -0.500% 0.0075% -0.785% 0.185% -1 1.200% 0.200% 0.0075% 0.308% 0.892% 0 2.500% 0.300% 0.0075% 0.464% 2.036% 1 1.300% -0.200% 0.0075% -0.316% 1.616% 2 1.660% -0.100% 0.0075% -0.160% 1.820% 3 1.500% 0.100% 0.0075% 0.152% 1.348% 4 1.400% 0.200% 0.0075% 0.308% 1.092% 5 1.260% 0.350% 0.0075% 0.542% 0.718%

It is been seen from the following data that the market efficiency is semi strong as the market itself is been found to possess capabilities to rapidly adjust the stock prices with itself. Notably the following information can be put forth on this regard:

 Mean of Actual Return 0.00980909 Mean of Expected Return 0.00117817 Standard Deviation of Actual Return 0.00896331 Standard Deviation of Expected Return 0.00402591

Conclusion

Recommendation can be made regarding the fact that the market efficiency hypothesis has been prevailed in case of Tastegood Company and the fluctuations in the stick prices are consistent with that of the results that are obtained in Part 1. In accordance with the efficient market hypothesis it is been known that the market stock prices reflects all the information regarding the stocks and there exists uniformity within the information. The asset bubbles that gets created in this regard are due to the drive of rapid change in information and expectations but not due to the overly speculative behavior or irrationality. Notably, the exploitation of the mispriced securities can be possible through strategizing the short selling and developing the measure of mispricing which is termed as alpha and ultimately utilizing information about the stock alphas along with its volatilities to form an optimally risky portfolio.

References

Abor, J.Y., 2017. Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.

Almazan, A., Chen, Z. and Titman, S., 2017. Firm Investment and Stakeholder Choices: A Top?Down Theory of Capital Budgeting. The Journal of Finance, 72(5), pp.2179-2228.

Arthur, W.B., 2018. Asset pricing under endogenous expectations in an artificial stock market. In The economy as an evolving complex system II (pp. 31-60). CRC Press.

Atanasov, V., Pirinsky, C. and Wang, Q., 2018. Did the Efficient Market Hypothesis Affect Investment Practice? Evidence from Mutual Funds.

Gay, R.D., 2016. Effect of macroeconomic variables on stock market returns for four emerging economies: Brazil, Russia, India, and China. The International Business & Economics Research Journal (Online), 15(3), p.119.

Hamid, K., Suleman, M.T., Ali Shah, S.Z., Akash, I. and Shahid, R., 2017. Testing the weak form of efficient market hypothesis: Empirical evidence from Asia-Pacific markets.

Hong, H., Li, F.W. and Xu, J., 2018. Climate risks and market efficiency. Journal of Econometrics.

Johnson, N.B. and Pfeiffer, T., 2016. Capital budgeting and divisional performance measurement. Foundations and Trends® in Accounting, 10(1), pp.1-100.

Malenko, A., 2016. Optimal dynamic capital budgeting.

Warren, L. and Jack, L., 2018. The capital budgeting process and the energy trilemma-a strategic conduct analysis. The British Accounting Review.

Winfree, J.A., Rosentraub, M.S., Mills, B.M. and Zondlak, M.P., 2018. Capital Budgeting and Team Investments. In Sports Finance and Management (pp. 343-374). Taylor & Francis.

Zhang, Q., Huang, X. and Zhang, C., 2015. A mean-risk index model for uncertain capital budgeting. Journal of the Operational Research Society, 66(5), pp.761-770.

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