- 11 Marks
Question
a) Joebel Limited is a diversified company operating in different industries on the African Continent. The shares of the company are widely traded on the stock exchange and currently have a market price of GH¢3.20 per share. The company’s dividend payment over the last five years is as follows:
| Year | Dividend Per Share (DPS) (GH¢) |
|---|---|
| 2015 | 0.35 |
| 2014 | 0.32 |
| 2013 | 0.30 |
| 2012 | 0.29 |
| 2011 | 0.28 |
The Board of Directors of Joebel Limited is considering two main investment opportunities: one in the Oil and Gas sector and the other in the Hotel and Tourism sector. Both projects have short lives and their associated cash flows are as follows:
| Year | Oil & Gas (GH¢’000) | Hotel & Tourism (GH¢’000) |
|---|---|---|
| 1 | 85 | 180 |
| 2 | 175 | 195 |
| 3 | 160 | 150 |
The investment in Oil and Gas would cost GH¢400,000, while the investment in Hotel and Tourism would cost GH¢405,000. The Management of the Company has identified the industry beta for Oil and Gas as 1.2 and for Hotel and Tourism as 1.6. However, Joebel Limited’s company beta is 1.5. The average return on companies listed on the stock exchange is 25%, and the yield on Treasury bills is 20%.
Required:
i) Compute the Net Present Values (NPV) of both projects using the company’s weighted average cost of capital as the discount rate. (5 marks)
ii) Compute the NPV using a discount rate that takes into account the risk associated with the individual projects. (5 marks)
iii) Advise Management regarding the suitability and acceptability of the projects. (1 mark)
Answer
i) Computation of NPV for both projects Using WACC
Oil & Gas Project
| Year | Cashflow (GH¢’000) | Discount Factor @ 17% | Present Value (GH¢’000) |
|---|---|---|---|
| 0 | (400) | 1.000 | (400) |
| 1 | 85 | 0.855 | 72.68 |
| 2 | 175 | 0.731 | 127.93 |
| 3 | 160 | 0.624 | 99.84 |
| NPV | (99.55) |
Hotel & Tourism Project
| Year | Cashflow (GH¢’000) | Discount Factor @ 17% | Present Value (GH¢’000) |
|---|---|---|---|
| 0 | (405) | 1.000 | (405) |
| 1 | 180 | 0.855 | 153.90 |
| 2 | 195 | 0.731 | 142.55 |
| 3 | 150 | 0.624 | 93.60 |
| NPV | (14.95) |
ii) Projects NPV using CAPM
Oil & Gas Project
| Year | Cashflow (GH¢’000) | Discount Factor @ 26% | Present Value (GH¢’000) |
|---|---|---|---|
| 0 | (400) | 1.000 | (400) |
| 1 | 85 | 0.794 | 67.49 |
| 2 | 175 | 0.630 | 110.25 |
| 3 | 160 | 0.499 | 79.84 |
| NPV | (142.42) |
Hotel & Tourism Project
| Year | Cashflow (GH¢’000) | Discount Factor @ 28% | Present Value (GH¢’000) |
|---|---|---|---|
| 0 | (405) | 1.000 | (405) |
| 1 | 180 | 0.781 | 140.58 |
| 2 | 195 | 0.610 | 118.95 |
| 3 | 150 | 0.477 | 71.55 |
| NPV | (73.92) |
iii) Recommendation to Management
Given the high risk inherent in the Oil & Gas project, the Hotel and Tourism project should be selected, as it is more suitable for the company despite its lower NPV.
- Tags: Cost of Capital, Hotel & Tourism, Investment Appraisal, Net Present Value (NPV), Oil & Gas, Risk
- Level: Level 3
- Uploader: Dotse