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 Ð50,000 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

ânâ Nuts.

The following information describes the new product:

Additional investment on new plant and equipment will amount to Ð1.5

million. The sum will be financed using Ð1 million 5-year bank loan at

6% rate of interest per annum, and Ð0.5 million from retained earnings.

This ratio of financing is in line with our companyâs 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: Ð2.50 in years 1-3, rising to Ð2.75 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: Ð50,000 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 Ð50,000 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 ânâ 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 projectâs 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) Ð9.00 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 Ð400,000.

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 Ð1.20 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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