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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

0.009809091

Mean of Expected Return

0.001178168

Standard Deviation of Actual Return

0.008963309

Standard Deviation of Expected Return

0.004025906

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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