Question Tag: Financial Appraisal

Search 500 + past questions and counting.
Professional Bodies Filter
Program Filters
Subject Filters
More
Tags Filter
More
Check Box – Levels
Series Filter
More
Topics Filter
More
  • 20 Marks

AFM – Nov 2015 – L3 – Q2 – Discounted Cash Flow Techniques | Sources of Finance and Cost of Capital

Evaluate the financial viability of a proposed air conditioner manufacturing project using APV.

ABC Manufacturing Ltd (ABC) is an indigenous Ghanaian company that manufactures components used in air conditioners. The company now wants to manufacture air conditioners for sale in Ghana. Though the manufacture of air conditioners will be a completely new business, directors of ABC plan to integrate it into the company’s core business.

ABC has premises it considers suitable for the project. This premises was acquired two years ago at the cost of GHS50,000. ABC will acquire and install the needed machinery immediately, so production and sales can commence during the first year. The directors of ABC intend to develop the project for five years and then sell it to a suitable investor for an after-tax consideration of GHS20 million.

The following data are available for the project:

  1. The cost of acquiring and installing plant and machinery needed for the project will be GHS5 million at the start of the first year. Tax-allowable depreciation is available on the plant and machinery at the rate of 30% on reducing balance basis.
  2. Working capital requirement for each year is equal to 10% of the year’s anticipated sales. ABC has to make working capital available at the beginning of the respective year. It is expected that 40% of working capital will be redeployed to other projects at the end of the fifth year when the project is sold.
  3. It is expected that 2,000 units will be manufactured and sold in the first year. Unit sales will grow by 5% each year thereafter.
  4. Unit sales price is estimated at GHS2,200 in the first year. Thereafter, the unit sales price is expected to be increased by 10% each year.
  5. Unit variable cost will be GHS1,100 per unit in the first year. Unit variable cost is expected to increase by 8% each year after the first year.
  6. Fixed overhead costs are estimated at GHS1.5 million in total in each year of production/sale. One-half of the total fixed overhead costs are head office allocated overheads. After the first year of production/sales, fixed overhead costs are expected to increase by 5% per year.

ABC Ltd pays tax at 25% on taxable profits. Tax is payable in the same year the profit is earned. ABC Ltd uses 25% as its discount rate for new projects but the directors feel that this rate may not be appropriate for this new venture.

Currently, ABC can borrow at 500 basis points above the five-year Treasury note yield rate. Ghana’s government is enthused by the venture and has offered ABC a subsidized loan of up to 60% of the investment funds required at an interest rate of 200 basis points above the five-year Treasury note yield rate. ABC plans to use debt capital to finance the project by taking advantage of the government’s subsidized loan and raising the balance through a fresh issue of 5-year debentures. Issues costs, which can be assumed to be tax-deductible expenses, will be 5% of the gross proceeds from the debenture offer. The financing strategy for the project is not expected to affect the company’s borrowing capacity in any way.

ABC Ltd will be the first indigenous Ghanaian company to manufacture air conditioners in Ghana. However, it will be competing with XYZ Ltd, a listed company with majority shares held by foreign investors. The cost of equity of XYZ Ltd is estimated to be 20% and it pays tax at 22%. XYZ has 10 million shares in issue that are trading at GHS5.5 each, and bonds with total market value of GHS40 million.

The five-year Treasury note yield rate is currently 10% and the return on the market portfolio is 18%.

Required:
Evaluate, on financial grounds, whether ABC should implement the project or not. (20 marks)

Financial appraisal of ABC Ltd’s proposed air conditioner manufacturing project
The project presents different business risk (as it involves a new business venture) and increases
financial risk (as its financing method will increase the company’s gearing). In addition, there are associated financing side effects that need to be factored into the financial appraisal. Adjusted
present value (APV) will be a more efficient appraisal method than the traditional NPV
approach.

Step 1: Compute the base case NPV

Workings:

1. Tax-allowable depreciation

2. Cost of equity as if company is ungeared
As the new project is a completely new business, an appropriate cost of equity is one that
reflects the level of business risk associated with the new business. This can be derived from
that of the competitor, XYZ as under:
Using MM Proposition II with tax:

XYZ’s cost of equity, ke(g) = 20%
Market value of XYZ’s equity = 10m x GHS5.5 = GHS55m
Market value of XYZ’s debt = GHS40m
XYZ’s tax rate, t = 22%
Cost of debt, kd = 10% (taken to be the treasury note rate)

Step 2: Calculate PV of financing side effects
Financing side effects that apply in this case are –

  •  the issue cost and its associated tax shield
  • annual interest payments on debt financing
  • benefit from subsidized loan from the government
    Necessary adjustments for the financing side effects follow.

Notes:

  • The issue costs may be included in funds borrowed instead.
  • The calculation above assumes that the entire issue costs will be expensed in the
    first year. One may choose to amortize it over the 5-year forecast period and
    discount the annual tax shields accordingly.
  • PV of tax shield and subsidy benefit are based on the 5-year government debt yield
    rate. It may be discounted at the company’s cost of debt, 15% (5-year yield rate
    plus 500 basis points) on the grounds that the benefits will accrue to the company
    only when it is able to discharge its financial obligation and 15% reflects the credit
    risk of the company.

Step 3: Compute APV by adjusting base case NPV for financing side effects

Conclusion:
As the APV is positive, the value of ABC will increase if the proposed project is implemented.

  • 20 Marks

AFM – Nov 2015 – L3 – Q1 – International investment and financing decisions

Evaluate the financial viability of a Nigerian subsidiary using NPV and MIRR and assess the associated risks and mitigation strategies.

Ahomka Fruity Ltd (Ahomka), a listed company based in Ghana, produces fresh pineapple juice packaged in bottles and cans. The company has been exporting to Nigeria for many years, earning an annual after-tax contribution of NGN5 million. The company wants to establish a wholly-owned subsidiary in Nigeria to produce and sell its pineapple juice products over there. If a subsidiary is established and operated in Nigeria, Ahomka will cease exporting pineapple juice products to Nigeria. However, Ahomka plans to sell some raw materials and services to the subsidiary for cash.

Acquiring a suitable premise, required plant, and equipment, and installing the machinery will take the next two years to complete. Production and sales will commence in the third year and indefinitely.

Capital expenditure is estimated to be NGN10 million at the start of the first year and NGN5 million at the start of the second year. Ahomka will have to make working capital of NGN2 million available at the start of the third year, and this is expected to increase to NGN2.5 million at the start of the fifth year.

The proposed Nigerian subsidiary will produce the following pre-tax operating cash flows at the end of each of the first three years of production and sales:

Production/sales year Pre-tax operating cash flows (NGN ‘000)
1 2,800
2 4,500
3 5,200

The tax rate in Nigeria is 30%, and tax is paid in the same year the profit is earned. Capital allowance is granted on capital expenditure at the end of each year of production/sale at the rate of 30% on a reducing balance basis.

After the first three years of production and sales, post-tax incremental net operating cash flows will grow at a rate of 4% every year to perpetuity.

Ahomka plans to finance the project entirely with loans raised from Ghana at an after-tax cost of 18%. The maximum post-tax operating cash flows possible will be remitted to the parent company at the end of each year to help pay off the loans. Nigeria does not restrict fund remittance to a parent company outside of Nigeria, and there are no taxes on funds remittance.

The Naira-Ghana Cedi exchange rate is currently NGN55.40/GHS. Annual inflation is expected to be 18% in Ghana and 20% in Nigeria.

Required:
(a) Perform a financial appraisal of the project using the net present value and the modified internal rate of return (MIRR) methods, and recommend whether Ahomka should proceed with the project. (10 marks)

(b) Present a paper to the Board of Directors of Ahomka, which advises on potential risks the company might be exposed to if it proceeds with the Nigerian subsidiary project, and strategies the company could employ to avoid or manage the risks.
(Note: Professional marks will be awarded for presentation) (10 marks)

(a) Financial Appraisal of Proposed Subsidiary in Nigeria:

As funds will be remitted to the parent company at the end of each year, an appropriate approach to appraising the project is to:

  • Forecast foreign currency cash flows.
  • Forecast exchange rates.
  • Convert foreign currency cash flows to home currency cash flows using spot or forecast exchange rates as appropriate at the end of the year.
  • Discount home currency cash flows at the parent company’s domestic cost of capital to obtain project NPV in home currency.

(b) Paper on Risk Exposures Relating to the Nigerian Operation:

Introduction: Foreign operations present additional risks in excess of business risks, collectively referred to as country risk, which is the risk that unexpected changes in the business environment of the host country will affect the value and position of a company. This paper discusses potential political risks, financial risks, and other risks that could affect Ahomka if it proceeds with the Nigerian subsidiary project, and strategies for managing those risks.

Political Risks:

  1. Taxes and Tariffs: Changes in Nigeria’s tax rules could increase the corporate tax rate or introduce new taxes, reducing cash flows and company value.
  2. Local Content and Labor Regulation: Future regulations could demand higher local content or impose restrictions on expatriate workers, affecting operational plans.
  3. Protection of Intellectual Property: Weak protection laws and poor enforcement could lead to losses from intellectual property infringements.
  4. Protectionism: Protectionist measures, such as import quotas and currency devaluation, could reduce Ahomka’s expected cash flows.
  5. Foreign Exchange Controls: Government interference with the current floating exchange rate regime could affect profit repatriation and increase costs.

Financial Risks:

  1. Currency Risk: A strong Ghanaian cedi relative to the naira would reduce remitted cash flows from Nigeria.
  2. Inflation Risk: Higher-than-expected inflation in Nigeria could lower cash flows if price increases are insufficient to offset higher operating costs.
  3. Interest Rate Risk: Changes in interest rates in Ghana and Nigeria could increase the cost of the loan financing the subsidiary.
  4. Payment Delays: Payment delays from Nigerian distributors could lower the project’s net present value.

Agency Problems: Agency problems could arise between head office managers and the subsidiary’s managers, particularly due to conflicts in objectives.

Strategies for Avoiding or Managing the Risks:

  1. Negotiate for a Favorable Business Environment: Ahomka could negotiate with the Nigerian government for favorable terms, including tax holidays and favorable local content regulations.
  2. Structure Operations to Limit Exposure: Limit technology transfer, establish joint ventures with local partners, or license intellectual property to reduce exposure to political risks and manage blocked funds.
  3. Political Risk Insurance: Ahomka could obtain insurance to cover risks such as political violence, expropriation, or remittance restrictions.
  4. Hedge Currency Risk: Use financial derivatives like futures and options to manage currency fluctuations.
  5. Hedge Interest Rate Risk: Utilize interest rate swaps to manage exposure to interest rate changes.
  6. Align Interests to Manage Agency Problems: Use an effective group bonus scheme and performance evaluation that excludes factors beyond the subsidiary’s control.

Conclusion: While foreign investments come with inherent risks, Ahomka can manage these risks effectively. If the NPV remains positive, the project represents a valuable opportunity to enhance shareholder value.

Take control of your business data with insight and in-depth understanding by taking this course. 

Services

Contact Info

  • +233203701923
    +233543919232
  • info@noohrabusiness.com

Get In Touch

Follow us on our social media and get daily updates.

Facebook-f Twitter Linkedin-in Envelope