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Question
C321 Corporate Finance Session Two 2015
Assignment One
You are the financial manager of a British soft drinks company, TD Ltd, who are considering expanding their operations. They are considering investing in a new production & bottling plant, and have identified two possibilities. Option A involves constructing a new bottling plant in Scotland, and Option B involves constructing a new plant in the North of England. Both bottling plants will have a production capacity of 100,000 bottles per month, which will lead to monthly revenues of £50,000. TD Ltd think that ample demand exists for the expanded output. In fact, TD's management think that the market for their drinks will expand further in the future. They are currently selling all of the bottled drinks that they produce, and their current plants are operating at full capacity. Further details are as follows:
Weekly historical share prices of TD Ltd: not available, as TD Ltd is not a listed company. However, recent weekly share prices for TD's nearest competitor, Britvic plc, have been provided in a separate Excel file, along with corresponding values of a UK share index, the FT-All Share Index. You may assume TD Ltd has similar risk and capital structure to its competitor. These price data have been adjusted for the effects of dividends, so that total returns are captured in the share prices.
General details applicable to both projects:
UK corporation tax rate 20%
UK 10 year Treasury yields: 1.5%
CAPM market risk premium: 5%
OPTION A:
Variable material cost per bottle produced: £0.1
Annual fixed costs of operating the plant: £100,000 (excludes depreciation, but includes lease of land)
Annual depreciation of plant (in financial accounts): £10,000
Annual tax depreciation charge (i.e. annual depreciation charge allowable by tax authorities against taxable profits): £20,000
Estimated useful life of plant: 15 years. After this date, the plant would need to be rebuilt if production will continue. The proposed lease of the land allows TD Ltd an option to renew the lease for a further 15 years.
Capital investment cost of plant:
| Total cost of constructing plant | £8 00,000 |
| Grant available from local council | £100,000 |
| towards cost of plant |
C321 Corporate Finance Session Two 2015
The plant will take one year to build and get ready for operation. 25% of the cost of constructing the plant would be paid at the start of the project; 25% would be paid after 6 months; and the remainder would be payable when the plant is ready for operation. The grant from the local council can only be claimed after the plant has been operating for three years.
OPTION B:
Variable material cost per bottle produced: £0.09
Annual fixed costs of operating the plant: £140,000 (excludes depreciation, but includes lease of land)
Annual depreciation of plant (in financial accounts): £14,000
Annual tax depreciation charge (i.e. annual depreciation charge allowable by tax authorities against taxable profits): £28,000
Estimated useful life of plant: 20 years. After this date, the plant would need to be rebuilt if production will continue. However, TD Ltd cannot currently secure an option to renew the lease. They would therefore have to negotiate with the owner of the land at the end of the lease if they wish to rebuild the plant. It is not currently possible to predict whether the land owner would consent to renewal, or what lease terms they would agree to if renewal is agreed.
Capital investment cost of plant:
| Total cost of constructing plant | £90 0,000 |
| Grant available from local council | No grant available |
| towards cost of plant |
The plant will take two years to build and get ready for operation, because the previous owner of the land first needs to clear the land and make it ready for use. 20% of the cost of constructing the plant would be paid one year after the decision to go ahead; 25% would be paid after a further 6 months; and the remainder would be payable when the plant is ready for operation, at the end of the two-year period.
Required:
- For each project, calculate the NPV and the IRR. Also, advise on whether the pay-back period can be calculated for each project. If the payback period can be calculated, calculate it for each project.
(40% of marks)
- Using your answers to part (a), and any considerations you think may be important, advise TD Ltd on which project (if any), Option A or Option B, should be undertaken. As part of your answer, you should also discuss the usefulness of NPV, IRR and payback period in evaluating these investment opportunities, and explain any reservations you may have about the use of any of these techniques in this particular scenario.
(60% of marks)
C321 Corporate Finance Session Two 2015
Explain and illustrate your answer in no more than 2,500 words. This limit includes tables and captions but excludes footnotes, endnotes, tables of figures and references. Answers that exceed this limit will result in a loss of marks. Full details of penalties for late submission, exceeding the word limit and other information can be found at the end of this assignment.
Your assignment should be submitted via the Virtual Learning Environment (VLE) hosted on Moodle to The Centre for Financial and Management Studies no later
than 24th February 2015. Full instructions are available on the VLE.
Student Assignment Guidelines
The assignment questions above are based mainly on the material covered in Unit
- Net Present Value and Capital Budgeting Decisions, and the associated readings and textbook materials. In particular, you should find Section 2.2 (Investment Principles & Net Present Value) and Section 2.3 (Capital Budgeting Decisions) relevant, as well as your work on the Watergrass mini-case in Section 2.4. Some of the work in Section 2.5 (Sensitivity and Scenario Analysis may also provide inspiration for some of the discussion required in part (b). You will need to calculate a discount rate for your NPV valuations in part (a), and for this you have been provided with an Excel file of share price data for a competitor, and for a market index. You may assume that the competitor has a CAPM beta that is similar to that of the company whose projects you are analysing. You will find material in Unit 3 on the Capital Asset Pricing Model (CAPM) useful in determining the relevant discount rate, especially Section 3.3 on the CAPM, and the Security Market Line equation (equation 3.26 on page 25 of Unit 3). Note that the (Rm – R f) term in equation 3.26 is the 'market risk premium', which you have been given above as 5%. One approach to calculating the beta of a stock is to regress its weekly returns (not prices!) on the market index returns, and take the slope coefficient of the regression as the estimated beta. You will be able to do this in Excel using the 'Analysis Toolpak'(if you are using a PC) or using the SLOPE function in an Excel spreadsheet.
Your assignment must be properly referenced. Further information on referencing (ie the Harvard system) is available in the Studying at a Distance textbook by Talbot and on the Virtual Learning Environment in the Study Skills area.
Plagiarism
All assignments submitted must be your own work and written in your own words. Where you have used quoted material, you must make full reference to it. You must cite all references used throughout your work at the end of your assignment. Advice on what is classified as plagiarism and the action taken against this can be found in the University of London Regulations and on the Virtual Learning Environment in the Study Skills area.
C321 Corporate Finance Session Two 2015
Submitting Assignments
Students are required to submit their assignment in one place only on the Virtual Learning Environment using TurnItIn, the plagiarism detection software. A video tutorial and step-by-step instructions on how to do this can be found on the Virtual Learning Environment on your module assignment page.
Please see the information below for the current policy on penalties.
IMPORTANT INFORMATION
Late Submission
Assignments submitted after the published deadline will be penalised:
Marks will be deducted at a rate of two marks per working day (ie Mon-Fri, and a maximum of 10 marks for up to one week after the deadline). Assignments will not be accepted beyond one week after the deadline, and a mark of zero will be awarded to assignments submitted beyond one week late. There is no procedure for extensions.
Penalties for late submission of assignments (ie up to one week after the deadline) may be waived if all the following conditions are met:
- immediate, unexpected or unforeseen difficulties. Such difficulties may include: illness, bereavement, impact of disability, sudden and severe change in personal circumstances.
- The impact of such difficulties will be of a significant and unavoidable nature
- The request must be accompanied by relevant documentation (eg. medical certification)
Word count & Over length Assignments
The specified word count for the assignment includes tables and captions but excludes footnotes, endnotes, tables of figures, and references.
Over length assignments will be penalised as follows:
Up to and including 10% – 5 marks.
Between 10% & 20% – 10 marks,
Between 20% & 30% – 15 marks.
Over 30%. The assignment will not be marked but will be given a grade of 0.
In the case of assignments that are not essays, alternative but commensurate limits and penalties will be applied to over-length submissions
Referencing and Citation
Students are expected to use the Harvard system of referencing. Incorrect referencing can lead to penalties and if a student is found to have plagiarised other work it is an examination offence. For this reason, all assignments must be submitted to TurnItIn which checks your work against existing books, journals and other student assignments.
The penalties for plagiarism are set by the University of London. Please see the Study Skills resources on Referencing and Citation for detailed examples of how to reference correctly to avoid unnecessary deductions.
Eligibility for examination
Should a student sit an examination without having submitted the required number of assignments, the examination entry and/or examination result will be declared invalid.
Finance Assignment Solution
Question A:
Being the Financial Manager of the British Soft Drinks Company,TD Ltd , it is imperative that I review both the investment proposals Option A and Option B and choose the best one which would provide the best return on investment for the TD Ltd.
The management of TD Ltd thinks that there is a going to be a great demand for their bottled drinks in the future and hence the investment in a new bottling plant is vital. The existing plant is running at full capacity and all the bottled drinks produced are being sold.
Option A
I will now review Option A where the plant would be constructed in Scotland where the production capacity is 100,000 bottles per month and a monthly revenue of Rs.50000 is expected.
In order to make a good judgment whether Option A should be considered we would try to find out the return on investment through two different methods initially the Net Present Value (NPV) and the Internal Rate of Return (IRR).
NPV before the Renewal of Lease
It is important to find the NPV of a proposal to understand which investment proposal among the two options is favorable for the organization. The proposal with the higher NPV would be selected.
In order to find out the NPV of a particular investment proposal, we need to find the discount rate or the cost of capital. Hence the first step would be to find out the Weighted Average Cost of Capital (WACC) by calculating the Cost of Debt and the Cost of Equity.
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