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Valuing Shares and Evaluating Investment Options

## Question 1: Computing the intrinsic value of Firm A’s common shares

Assume today is 31 December 2021. Firm A, a commodity producer, is expected to adopt the following payout policy for the next 4 years:

 Year 2022 2023 2024 2025 Dividends (\$’ m) 9 12 5 0

The estimated net profit after tax is \$50 million for the year 2025. The company has no preference share financing, and does not plan to do so for the next 4 years. The expected price-earnings ratio by the end of year 2025 is 15 times. Shareholders of Firm A require a return of 10 percent for shares in this risk class.

1. Compute the intrinsic value of Firm A’s common shares.

2. Critically evaluate the use of the Dividend Discount Model in valuing the shares of Firm A, and explain which alternative methods may be more appropriate.

Note: To show all workings with accompanying explanations.

Word count requirement: 500 (actual word count to be stated on the cover page of the assignment). Minimum number of references: 2.

Wonder Works Pte Ltd (‘WW’) produces hair curlers. The equipment for this task cost WW \$70,000 four years ago. The reduced book value now stands at \$45,000. An improved version of the machine is currently available for \$139,350. The new machine has a useful life of five years. The disposal value at that point in time is estimated to be \$20,000.

The new machine is expected to increase unit sales by 6,000 curlers per annum. The estimated unit selling price is \$35 for the first year.

The following table provides the unit costs for the first year:

 \$ Direct labour, 5 hours at \$2 per hour 10 Direct materials 7 Fixed costs including depreciation 11 Total 28

WW is short of production workers due to the COVID-19 pandemic in Singapore. It has decided to divert some labour from another project to the new project. These workers earn a contribution of \$2 per direct labour hour in their original department. The fixed overhead cost would be \$2.20 per hour and this is expected to remain unchanged.

The sales agreement for the curlers allows the selling price to rise at the rate of 10 percent per year after the first year. The unit costs, except for fixed costs, is expected to increase at the same rate as the selling price.

Working capital requirements are expected to be \$15,000 in the first and second years, increasing to \$18,000 in the third year and is expected to remain at this level till the end of the project. All the amounts of working capital will be recovered at the time of project termination.

WW enjoys a tax holiday for the next five years. The required return for projects of this risk class is 27 percent per annum.

Identify the relevant cash flows for the decision as to whether or not WW should proceed to purchase the new machine.

Note: To show all workings with accompanying explanations.

Word count requirement: 800 (actual word count to be stated on the cover page of the assignment). Minimum number of references: NIL.