Champion Co Investment Appraisal
Champion is considering the purchase of new equipment which will enable the company to expand its operations. The equipment will cost £1.2 million and have a three-year life; at the end of which it will have a scrap value of £600,000. The equipment will mean that Champion will require more factory space at an annual rental of £80,000; payable in advance, with the first payment being made on the day the equipment is purchased.
Further annual fixed costs charged to the project will be £715,000 in total. This includes £86,000 of bank interest payable on the loan to cover the cost of the equipment. £74,000 of costs allocated out of head office overheads. A depreciation charge for the new machinery that has been calculated using the straight?line method over the life of the machine.
Additional annual sales are expected to be 60,000 units per annum in each of the three years. Each unit will sell for £40 and has a variable production cost of £25. A further investment of £350,000 will be required for working capital. This will need to be in place at the start of the year. This amount will increase to £410,000 in the following year, and £460,000 in the year after that. This working capital investment will be fully recovered at the end of the project.
If Champion buys the new equipment, then it can claim capital allowances on the investment on a 25% reducing balance basis. The company pays taxes in the year to which it relates at an annual rate of 30%. Champion uses a cost of capital of 11% per annum for appraising its investments.
i. Prepare a forecast of the annual after-tax cash flows of the investment and calculate and comment on its net present value. Calculate the sensitivity of your answer to changes in the expected annual sales in units and the estimated sales proceeds of the equipment. (15 marks)
ii. Discuss the implications of your findings to Champion. (10 marks)
iii. Explain the difference between risk and uncertainty and describe two methods that a company can use to incorporate either risk or uncertainty when appraising investments. (10 marks)
Sales for the year to 30 April 2019 were £89m, yielding a gross profit of £8.7m and a profit before tax (after finance costs) of £8.2m. At the beginning of the year to 30 April 2020, the company bought new manufacturing equipment and recruited six more sales staff. Sales for the year to 30 April 2020 were £131m, with an operating profit of £8.5m, and a profit before tax of £7m.
Claudia Co Cash Conversion Cycle and Financing
a. Explain the cash conversion cycle and its significance in determining the working capital needed by a company. (5 marks)
b. Calculate the cash operating cycle of Claudia for the years ending 30 April 2019 and 2020. (8 marks)
c. Using additional calculations, with your results to part (b), discuss whether or not Claudia is overtrading. (10 marks)
d. Explain the different strategies a firm may follow to finance its working capital requirements. (5 marks)
e. Suggest ways in which Claudia might seek to resolve its current funding problems, and avoid the risks associated with overtrading. (7 marks)
Alliance is a stock market listed manufacturing company that is seeking £10m additional finance to undertake a new project. The finance director of Alliance is currently considering whether to raise the capital by debt or equity finance. The capital structure of the company (before the new finance has been raised) is as follows:
The ordinary shares are currently trading at £1.70 each. The company’s cost of equity has been estimated at 15%. Bond A will be redeemed at par in six years’ time and pays a fixed annual interest of 8%. The pre?tax cost of this finance has been estimated at 10%. The bank loan is repayable in two years’ time. It is a floating rate loan at LIBOR + 1%. LIBOR is currently at 3%.
Initial enquiries by the finance director have indicated that further fixed rate debt finance could be raised at an annual post?tax cost of 7%. Floating rate debt finance could be obtained for LIBOR + 2%. Market experts are divided over the expectations of future interest rates, with some expecting rates to remain steady for the foreseeable future, and others predicting an increasing of up to 4%. Alliance pays corporation tax at a rate of 30%.
i. Calculate the current market value of Bond A. (6 marks)
ii. Calculate the current weighted average cost of capital of Alliance (14 marks)
iii. Evaluate the impact on the weighted average cost of capital of raising the new finance by equity and fixed rate debt. State any assumptions that you make. (10 marks)
You must submit your assignment by using the Turnitin gateway in the module’s Canvas site.
Please Note: When you submit you will be asked to confirm you have referred to the Submission Checklist (see Appendix 1) and the act of submitting your work electronically will be taken as an acceptance of the Declaration of Authorship (see Appendix 2).
This item of assessment covers the following learning outcomes. For the full list of learning outcomes for the module, please refer to the Module Study Guide.
• Understand and critically analyse the role of the financial function, sources of finance and decision making with regards to the operation of financial structures
• Demonstrate a detailed knowledge and analytical understanding of the principles, techniques, investment strategies and practical functions of financial management in the context of an organisation structure and corporate dilemmas
• Critically explain qualitative and quantitative financial concepts and the relevance of investment decisions in relation to different stakeholders
• Develop key skills: communication (C2), problem solving (C5), processing of numerical data (C7)