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BC plc is considering the introduction of a new breakfast cereal on which it has already spent 50,000 on technical and feasibility studies.

BC plc is considering the introduction of a new breakfast cereal on which it has already spent £50,000 on technical and feasibility studies.  The new product will be a variation of our current breakfast cereal, Crunch Stuff, with the exception that it will contain sugar-coated roasted nuts. Consequently, it will be called Crunch Stuff 'n' Nuts.
The following information describes the new product:
 Additional investment on new plant and equipment will amount to £1.5 million. The sum will be financed using £1 million 5-year bank loan at 6% rate of interest per annum, and £0.5 million from retained earnings. This ratio of financing is in line with our company's current gearing ratio.
 Production and sales, estimated from market research are projected as follows:
Year Units Produced and Sold
1 1,000,000
2 1,300,000
3 1,600,000
4 1,800,000
5 2,000,000
  
It is believed that about 10 percent of these projected sales will come from former Crunch Stuff customers who have switched to the new product.
 Sales price per unit: £2.50 in years 1-3, rising to £2.75 in year 4-5 in real terms.
 Variable costs, advertising and sales promotions: 50% of unit sales price in years 1-2, 52% in years 3-4, and 53% in year 5
 Annual fixed cost: £50,000 per annum, rising at 2% per annum. 20% of annual fixed costs come from a re-allocation of the annual fixed cost from existing product lines.
 Working capital: an initial working capital investment of £50,000 will be required just to get production started. For each year, the total investment in working capital will be equal to 10% of the value of sales.
 Depreciation method: use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years.
Other relevant information
 BC plc falls within 25% corporation tax band, and pays tax 12 months in arrears.
 BC plc currently has a nominal weighted average cost of capital of 15% after tax.
 The company appraises new project using nominal cash flows.
 Inflation rate in the UK over the next five year is project to be 2.5 percent per annum.
Required:
Mr. Alexander concluded his email to you by requesting to respond to the following questions:
a) How do sunk costs affect the determination of the cash flows associated with investment project?
b) Why do we focus on cash flows rather than accounting profits in making investment decisions?
c) Why should we be interested in incremental cash flows rather than total cash flows?
d) How should we calculate and treat working capital in investment appraisal?
e) How should we treat taxable depreciation allowance in investment appraisal?
f) Are financial charges and loan repayments relevant cash flows when using the net present value method of investment appraisal? Explain.
g) Why is it necessary for BC plc to finance the new product using both debt and equity capital in the same proportion as its current level of gearing?
h) How do we ensure consistency in the treatment of inflation in investment appraisal?
i) Derive the net cash flow of the new Crunch Stuff 'n' Nuts products. Show all workings and make clear any assumptions you make.
j) Is the new product financially viable on the basis of its net present value?
k) Using Excel, demonstrate and explain how you would evaluate the sensitivity of the project's NPV to changes in the estimates of unit sales price, annual sales volumes and variable costs.
l) What are the key merits and limitations of your analysis in (k) above?
      

BC plc is considering the introduction of a new breakfast cereal on
which it has already spent Ј50,000 on technical and feasibility
studies. The new product will be a variation of our current breakfast
cereal, Crunch Stuff, with the exception that it will contain
sugar-coated roasted nuts. Consequently, it will be called Crunch Stuff
‘n’ Nuts.
The following information describes the new product:
Additional investment on new plant and equipment will amount to Ј1.5
million. The sum will be financed using Ј1 million 5-year bank loan at
6% rate of interest per annum, and Ј0.5 million from retained earnings.
This ratio of financing is in line with our company’s current gearing
ratio.
Production and sales, estimated from market research are projected as
follows:
Year Units Produced and Sold
1,000,000
1,300,000
1,600,000
1,800,000
2,000,000
It is believed that about 10 percent of these projected sales will come
from former Crunch Stuff customers who have switched to the new product.
Sales price per unit: Ј2.50 in years 1-3, rising to Ј2.75 in year 4-5
in real terms.
Variable costs, advertising and sales promotions: 50% of unit sales
price in years 1-2, 52% in years 3-4, and 53% in year 5
Annual fixed cost: Ј50,000 per annum, rising at 2% per annum. 20% of
annual fixed costs come from a re-allocation of the annual fixed cost
from existing product lines.
Working capital: an initial working capital investment of Ј50,000 will
be required just to get production started. For each year, the total
investment in working capital will be equal to 10% of the value of
sales.
Depreciation method: use the simplified straight-line method over five
years. It is assumed that the plant and equipment will have no salvage
value after five years.
Other relevant information
BC plc falls within 25% corporation tax band, and pays tax 12 months in
arrears.
BC plc currently has a nominal weighted average cost of capital of 15%
after tax.
The company appraises new project using nominal cash flows.
Inflation rate in the UK over the next five year is project to be 2.5
percent per annum.
Required:
Mr. Alexander concluded his email to you by requesting to respond to the
following questions:
How do sunk costs affect the determination of the cash flows associated
with investment project?
Why do we focus on cash flows rather than accounting profits in making
investment decisions?
Why should we be interested in incremental cash flows rather than total
cash flows?
How should we calculate and treat working capital in investment
appraisal?
How should we treat taxable depreciation allowance in investment
appraisal?
Are financial charges and loan repayments relevant cash flows when using
the net present value method of investment appraisal? Explain.
Why is it necessary for BC plc to finance the new product using both
debt and equity capital in the same proportion as its current level of
gearing?
How do we ensure consistency in the treatment of inflation in investment
appraisal?
Derive the net cash flow of the new Crunch Stuff ‘n’ Nuts products.
Show all workings and make clear any assumptions you make.
Is the new product financially viable on the basis of its net present
value?
Using Excel, demonstrate and explain how you would evaluate the
sensitivity of the project’s NPV to changes in the estimates of unit
sales price, annual sales volumes and variable costs.
What are the key merits and limitations of your analysis in (k) above?
Q2
ABC plc is considering launching a takeover bid for XYZ plc. The two
companies are in the industry and have identical cost of equity capital,
which is 12% after tax.
Below is an extract of some financial data on both companies:
ABC plc XYZ plc
Earnings per share (eps) 50 pence 10 pence
Dividend per share (dps) 25 pence 5 pence
Price per share (pps) Ј9.00 75 pence
Number of shares 5 million 3 million
XYZ plc is expected to produce growth in dividend per share of 5% per
annum to infinity with its current strategy and management. However, if
ABC plc acquired XYZ plc, the resulting synergy from the acquisition
would be such that the growth rate of dividend per share for XYZ plc can
be raised to 8%. In addition, ABC plc is also confident that it can
bootstrap the earnings of XYZ plc using its own higher P/E after the
acquisition of the company.
The transaction costs of the acquisition, which covers payment to the
investment banks and accountants advising ABC plc, are estimated to
amount to Ј400,000.
Required:
Calculate the total value of the synergy that would be created from the
combination of ABC plc and XYZ plc:
using constant-growth dividend valuation model
using Price-earnings multiplier model
Comment on the limitations of the valuation models you have used in (a)
above in the particular situation of this case scenario.
Explain the possible sources of synergy arising from the acquisition of
XYZ plc by ABC plc.
If ABC plc paid Ј1.20 cash for each share of XYZ plc, what value of the
synergy calculated in (a ii) above would be available to the
shareholders of each company?
What are the advantages and disadvantages to ABC plc of paying cash to
acquire XYZ plc?
Using two recent cases, discuss the ways in which UK companies, which
have been the subject of unwanted (hostile or unfriendly) takeover bids
defended themselves from such bids.

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