“FINANCIAL

MANAGEMENT”

MESBAH FCA
 Chapter – 02 : Investment appraisal
Recap of investment appraisal techniques

Payback = The time taken for cash inflows from a project to equal the cash outflows.

Accounting rate of return (ARR) = Average annual profit from investment / Initial investment X 100

= Average annual profit from investment / Average investment X 100

Where, Average investment = (Initial Outlay + Scrap value)/2

Note : Profit is after depreciation.

Net present value The maximum an investor would pay for a given set of cash flows (at his/her cost of capital) compared to the actual amount he/she is being
asked to pay.

The difference, the NPV, represents the change in wealth of the investor as a result of investing in the project.

Internal rate of return A cost of capital at which the NPV of a project would be Tk. 0.

IRR is usually found via interpolation using two discount rates.

IRR = a + NPVa/ NPVa -NPVb X (b-a)

Where, a is the first discount rate giving positive NPV

b is the second discount rate giving negative NPV
Interactive question - 01

A company is considering expanding its business. The expansion will cost Tk. 350,000 initially for the premises and a further Tk.150,000 to
refurbish the premises with new equipment. Cash flow projections from the project show the following cash flows over the next six years.

Year Net cash flows

Tk.
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000

The equipment will be depreciated to a zero resale value over the same period and, after the sixth year, it is expected that the new business
could be sold for Tk. 350,000.

Requirements
Calculate
(a) The payback period for the project in nearest month
(b) The ARR (using the average investment method)
(c) The NPV of the project. Assume the relevant cost of capital is 12% 3
(d) The IRR of the project
a)
Cumulative CF (Tk.) DF @ 10%
Time Cash flow (Tk.)
(1/(1+r)n Discounted CF Cumulative
CF (Tk.)
PV of

1 70,000 70,000 0.909 63,630 63,630

2 70,000 140,000 0.826 57,820 121,450
3 80,000 220,000 0.751 60,080 181,530
4 100,000 320,000 0.683 68,300 249,830
5 100,000 420,000 0.621 62,100 311,930
6 120,000 540,000 0.564 236,880 548,810

Payback period = 5 years + [ (500,000 – 420,000) / 120,000X 12 months

= 5 years 8 months (Appx.)

b) Profit calculation:

Total cash flows from operations 540,000

Total depreciation (150,000)
Total profits = 390,000
Average profits ( / 6) = Tk. 65,000 p.a.

Average investment calculation (500,000 + 350,000) / 2

= 425,000
Average Initial
= 65,000/
ARR = 65,000/ 425,000 500,000
= 15.3% = 13%
C) NPV @ 12%

Time Cash flow Discount factor (DF) @ 12% (1/(1+r)n Present Value
0 (500,000) 1.000 (500,000)
1 70,000 0.893 62,510
2 70,000 0.797 55,790
3 80,000 0.712 56,960
4 100,000 0.636 63,600
5 100,000 0.567 56,700
6 470,000 (120+350) 0.507 238,290
NPV 33,850

d) NPV @ 20%

Time Cash flow DF @ 20% Present Value

0 (500,000) 1.000 (500,000)
1 70,000 0.833 58,310
2 70,000 0.694 48,580
3 80,000 0.579 46,320
4 100,000 0.482 48,200
5 100,000 0.402 40,200
6 470,000 0.335 157,450
NPV (100,940)

IRR = 12 (Lr)+ (33,850 (NPV Lr/ 33,850 NPV Lr + 100,940 NPV Hr ) X (20-12)
Consideration of non-financial factors
Although projects with positive NPV are an indication of a desired investment, other
factors such as real option and risk are also relevant. In addition, non-financial factors
need to be considered which could ultimately affect shareholder value. They may
include the following :

- Compliance with current and future legislation : May stop investment

- Impact on staff morale : workload, lack of adequate resource
- Impact on supplier and customer : Automate service
- Reputation of organization : unethical decision and action
- Sustainability : no compromise
Relevant Cash flows
Why cash flows rather than profits?

i. When a firm makes a long-term investment in a project, rarely does the profit in any year of the project’s life equal
the cash flow. For example, in cash flow terms the purchase of plant and equipment may be represented by an
outflow at the start of the first year (i.e. the purchase) and an inflow at the end of the last year (i.e. the scrap value).
In the annual income statements in between, what appears is the difference between the initial cost and the scrap
value, i.e. depreciation, which is not a cash flow.

ii. In addition, profit measurement is concerned with the time period in which income and expenses are
recognised. Thus, while the income statements might show Tk.100,000 for sales, the actual cash receipts may be
much less as some cash is still to be received, i.e. there are receivables. This increase in receivables represents a
further 'investment' in the project.

iii. From a wealth point of view shareholders will be interested in when cash goes out and when it is returned to
them in the form of dividends, i.e. the amount and timing of the flows are important to them.

iv. Over the life of a project the undiscounted net flows will equal the total accounting profit/loss but (because of the
above) the timing will be different.

v. It is also important to appreciate that not all cash flows are necessarily relevant. In Management Information the
behaviour of costs was introduced. Over a given period some costs are fixed and some variable. Whilst all of the costs
for a period will be reflected in the income statement i.e. they will influence the profit, they may not all be relevant
cash flows for a particular decision, e.g. depreciation.
 Profits to cash flows
If income statement information is provided, there are two adjustments which should be made to convert to cash flows:
• Depreciation
• Working Capital
Working capital – A project may involve not only investment in land, buildings etc but also investment in working capital (inventory +
receivables – payables). Increases in net working capital represent an outflow, decreases an inflow.

Worked example: Working capital

Gorgon plc expects the following sales from a new project over its three year life:
Time Taka
t1 150,000
t2 175,000
t3 200,000
Working capital equal to 10% of annual sales is required and it needs to be in place at the start of each year.
Calculate the working capital flows.

Solution
First, calculate the absolute amounts of working capital needed at the start of each year and then find the cash flows.

to t1 t2 t3
Tk. Tk. Tk. Tk.
Working capital at start 15,000 17,500 20,000 Nil
Cash flow -15,000 -2,500 -2,500 20,000

Only the incremental flow is relevant, so for example at t 1 an additional Tk. 2,500 is required over and above the Tk. 15,000 already in place.

At the end of the project all working capital is assumed to be recovered, i.e. an inflow of Tk. 20,000 at t 3.
Q. Changing working capital
A company plans to enter a four-year project that is forecast to generate revenue of Tk. 100,000 at t 1, increasing by 10% per annum until t4.
Working capital equal to 15% of annual sales is required at the start of each year, and will be fully recovered at the end of t4.

Requirement
What are the working capital cash flows?

Answer:
to t1 t2 t3 t4
Sales 100,000 110,000 121,000 133,100
Working capital required 15,000 16,500 18,150 19,965 0
Cash flow -15,000 -1,500 -1,650 -1,815 19,965
Relevant cash flows

The relevant cash flows are future, incremental, cash flows arising from the decision being made. The relevant cash flow is the
difference between:

i. The cash flow if the course of action is taken, and

ii. The cash flow if it is not

The assessment of relevant cash flows needs to be done from the point of view of the business as a whole and not individual divisions or
departments.

Typical items which are excluded from the analysis as irrelevant are discussed below:

Sunk costs – money already spent,

Accounting entries – e.g. depreciation (as discussed above) is not a cash flow
Unavoidable costs – money already committed, eg: non cancellable lease

Finance costs – e.g. Interest

All opportunity costs and revenues

Opportunity costs
The opportunity cost of a resource may be defined as the cash flow forgone if a unit of the resource is used on the project instead of in the best
alternative way.

If there are scarcities of resources to be used on projects (e.g. labour, materials, machines), then consideration must be given to revenues
which could have been earned from alternative uses of the resources.

i. Shareholders are concerned with the flows generated by the whole organisation in terms of assessing their impact on their wealth

ii. The cash flows of a single department or division cannot therefore be looked at in isolation. It is always the cash flows of the whole
organisation which must be considered.

iii. For example, the skilled labour which is needed on the new project might have to be withdrawn from normal production causing a loss in
contribution. This is obviously relevant to the project appraisal.
Deprival value
When an asset which is currently owned by the business is required for another specific contract/project, the existing activity is to be deprived of
that asset. The value to be used in the investment appraisal is, therefore, the asset's deprival value.

Worked example: Deprival value

A company has a printing press which needs to be used on a new contract. The press could be sold for Tk. 1,000 or made use of to service the
needs of existing customers for business which has a value (in present value terms) of Tk. 1,500.

Requirements
(a) What is the opportunity cost of using the machine on a new contract?
(b) If the printing press could be replaced at a cost of either
(i) Tk. 800
(ii) Tk. 1,800
What would the relevant cost be?

Solution
(a) The existing customers create more value than selling the machine, so the machine would not be sold. Hence the opportunity cost is the value
in use of Tk.1,500

Note: if the value in use ever dropped below the net realisable value (NRV), then the asset would not be worth keeping.

(b) (i) If the new contract will make use of a currently owned machine then in principle the cost of using it will be the replacement cost. If the
value in use is Tk. 1,500, and the replacement cost is Tk. 800, then the therefore be Tk. 800. machine will be replaced. The equipment cost of the
new contract would therefore be Tk. 800

(ii) If however, the replacement cost is Tk. 1,800 then it is not worth replacing. Thus the relevant cost of equipment for the new contract will be
the opportunity cost or benefit forgone – i.e. the Tk. 1,500.

In each case therefore the relevant cost is the cash flow effect of the decision to use the existing resource – either the replacement cost or the
benefit in the next best case, i.e. the deprival value.
Q: Deprival value

JX Ltd. Owns a machine purchased two years ago for Tk. 2,000. A similar machine would now cost Tk. 1,000. The machine could be sold for Tk.
1,000 after spending Tk. 100 on advertising. The machine has two years of life remaining, and over this period the cost of renting the machine
instead would be a present value of Tk. 800.

Requirement
What is the loss to Joe if his car is stolen?

Answer :
The recoverable amount is the Tk. 900 NRV (which is higher than the Tk. 800 economic value). As this is lower than the Tk. 1,000 replacement
cost, Tk. 900 is the deprival value.
 Work Example : Taxable Profit
Tk Tk
Sales 10,000
Materials (1,000)
Labour (1,500)
Variable overheads (500)
Fixed Overheads
Depreciation (1,000)
Other (500)
(4,500)
5,500
Interest on loan to finance project (3,000)
Profit 2,500

Taxation has two effects in investment appraisal, both giving rise to relevant
cash flows:

1.Outflow : Tax charged on net cash flows

2.Inflow: Tax relief on assets purchased via capital allowances
Worked example: Capital Allowances
Continue…
Happy Ltd bought a machine for Tk. 10,000 on 31 December 20X1, its accounting year end. The asset generated cash flows of Tk. 7,000 pa. It sold the asset
on 31 December 20X3 for Tk. 2,000.

20X1 20X2 20X3

Acquired Disposed
The company pays tax at 17%. Capital allowances are available at 18% on a reducing balance basis. Show the WDAs and any balancing charge or allowance.

Solution
Year ended 31 Dec Tax WDV (WDV = written down value)
Tk.
20X1 10,000
TDA @ 18% -1,800

20X2 8,200
TDA @ 18% -1,476

20X3 6,724
Proceeds -2,000

Balancing allowance 4,724

Total reliefs = Tk. (1800+1476+4724) = Tk. 8,000 (= Cost – Scrap). Tax payments, cash flows etc can then be shown as follows:

Tax computation
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3

Net inflows 7,000 7,000

TDA/Balancing allowance (1,800) (1,476) (4,724)
Taxable (1,800) 5,524 2,276
Tax @ 17% 306* (939) (387)
* Tax saved, assuming sufficient profits exist elsewhere in the business to obtain relief from TDA as soon as possible.
Normally the tax effect is shown as two separate elements:
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3
Net inflows 7,000 7,000
(1) Tax paid @ 17% (1,190) (1,190)
TDAs/Balancing allowance (1,800) (1,476) (4,724)

(2) Tax saved @ 17%* 306 251 803

Total tax (above) (1) + (2) 306 (939) (387)

* i.e. being able to deduct the TDA from profit saves tax @ 17%.

The NPV calculation would show (rounding to the nearest Tk.):

31 Dec 20X1 31 Dec 20X2 31 Dec 20X3

Net inflows - 7,000 7,000
Tax - (1,190) (1,190)
Asset purchase (10,000) - -
Scrap - - 2,000
Tax saved on TDAs 306 251 803
Net CF for discounting (9,694) 6,061 8,613
Q : Tax Depreciation
1. A company buys an asset for Tk. 10,000 at the end of its accounting period, 31 December 20X0, to undertake a two year
project.
2. Net trading inflows at t1 and t2 are Tk. 5,000.
3. The asset has a Tk. 6,000 scrap value when it is disposed of at the end of year 2.
4. Tax is charged at 30%. TDAs are available at 25% pa

Requirement
Calculate the net cash flows for the project.
to t1 t2
Net trading revenue - 5,000 5,000
Tax @ 30% - (1,500) (1,500)
Asset (10,000) - 6,000

TDA (W) 750 563 (113)

Net cash flow (9,250) 4,063 9,388

Working
to t1 t2
Profits in prior year

i. Asset purchased 31 dec 20x0

ii. First TDA will be set off against profits earned in y/e 31 dec 20X0
iii. First tax relief at to
iv. Asset scrapped 31 dec 20X2
v. No TDA in year of sale - balancing adjustment instead.
 Tax relief at 30% Timing
31 Dec 20X0 Investment in asset 10,000
TDA @ 25% (2,500) 750 to
7,500
31 Dec 20X1 TDA @ 25% (1,875) 563 t1
5,625
31 Dec 20X2 Proceeds 6,000
Balancing charge (375) (113) t2

Asset value dropped 10,000 – 6,000 4,000

TDA claimed 2,500 + 1,875 (4,375)
Relief reclaimed ('clawed back') 375

Replacement analysis

So far it has been assumed that investment in an asset is a one-off decision. However, a project is likely to involve
commitment to long-term production, and machinery will therefore need to be replaced

A business needs to know how often to replace such assets. Replacing after a long time means not replacing as often, so
delaying the cost of a new replacement machine. However, this invariably means keeping an asset whose value is declining
and which costs more to maintain. These costs and benefits need to be balanced.
 Inflation
• Inflation rate can be incorporated into both cash flows and the discount rate
• Inflation can be ignored in both cash flows and the discounted rate

Real and money (or nominal) rates

• The rate of interest that would be required in the absence of inflation in the economy are
referred to as the real rates of interest.
• When the real rates of interest are adjusted for the effects of general inflation, measured
by the consumer price index (CPI), the results are referred to as money (or nominal) rates
of interest.
Example :
Kuman is considering a choice, he can spend Tk. 100 on consumables now or he can invest it for a year, but
will only do so if he can consume more of it at that time.
The underlying real rate of interest for Kuman is 10% and general inflation is 5%.

Requirement : What return in money terms does Kuman require ?

Real Term : r =10%, 1 year later Tk. 110 is the amount required to satisfy the consumption preference, Kuman
needs to be able to purchase 10% more goods.

Money Term : The impact of inflation means that in order to be able to purchase 10% more goods Kuman
needs Tk. 110 X 1.05 = Tk. 115.50
Overall money required = Tk. 15.50/Tk.100 = 15.50%
 Money rates, real rates and general Inflation are linked by Fisher’s equation : (1+m) = (1+r)(1+i)

Where :
m = money rates , r= real rate, I = general inflation
Thus, in the example above : (1+m)= (1.10)(1.05)
m = 15.50%
Money and current cash flows:
• Money (or nominal) cash flows where any inflationary effect have already
been taken into account
• Current cash flows are cash flows expressed in today’s terms which will be
affected by inflation in the future and have not yet been adjusted.
General and specific inflation rates:
• A general inflation rate is a weighted average of many specific inflation rates
and is normally applied to the real rate in order to derive the money rate.
• A specific inflation rate is the expected rate of inflation for an individual item
of revenue, savings or cost. Such as, the rate at which labour costs per hour
will increase.
Environmental Costing :
- The impact on the environment of new ventures should be considered as part of the investment appraisal process.
- Environmental costs can be classified as prevention, appraisal, internal failure and external failure costs.

Managing environmental costs:

- Environmental costs such as energy costs are often treated as production overheads and therefore effectively hidden from the
management scruniny.
- The difficulty lies in pinpointing environmental costs are listed below :

* Consumables and raw materials.

* Transportation and travel
* Waste
* Waste and effluent disposal
* Water consumption
* Energy

Benefits of understanding environmental costs:

- Environmental costs associated with individual products, service or processes helps with correct product or service pricing.
- Poor environmental behaviour can result in fines, increased liability to environmental taxes and damages to the business reputation.
- Record environmental costs to meet regulatory compliance.
- Saving energy generally leads to cost savings.

Environmental cost classification :

It is useful to classify environmental costs under four headings:
- Environmental prevention costs
- Environmental appraisal costs
- Environmental internal failure costs
- Environmental external failure costs.
Capital rationing :

The situation where insufficient funds exist to undertake all positive NPV projects, so a choice must be made between projects.

Types of rationing :
- Hard rationing
- Soft rationing

Single period rationing :

- When funds are scarce in one year only, but freely available otherwise, the selection of divisible projects for investment is based on a
simple ranking system.

Indivisible projects :

In reality projects may be indivisible, the investment is all or nothing. In this case trial and error is necessary to find the optimal
combination.

Mutually exclusive projects:

Projects are mutually exclusive. It is not possible to undertake both at the same time, perhaps because management would be
overstretched in trying to run both projects.
Shareholder Value analysis (SVA) :
The process of analysing the activities of a business to identify how they will result in increasing shareholder wealth.
Shareholder Value analysis (SVA) :
- A business has a particular value at a particular time because of the expected future cash flows from its activities.
- The value will be based on their timings and riskiness.
- According to principles of SVA, The value of the business is affected or 'driven' by just seven factors.
 - These seven factors all impact on the operating cash flows and through them, the value of the business and the wealth of the shareholders.
These will be examined in turn and related to individual parts of the business.
* Sales growth rate
* Operating profit margin
* Corporate tax rate
* Investment in non-current assets
* Investment in working capital
* Cost of capital
* Life of a projected cash flows

How can SVA be used :

- Most useful in highlighting the key drivers of value.
- Enabling managers to set targets for achieving value enhancing strategies in each areas.

- To create an environment where value enhancement is at the top of the agenda for managers in all areas of the business.

Real Option

Situation could be :
- follow up options
- Abandonment options
- Timing options
- Growth options
- Flexibility options
Investing overseas

When deciding what types of country it should enter (in terms of environmental factors, economic development, language used, cultural
similarities and so on), the major criteria for this decision should be as follows.

(a) Market attractiveness. This concerns such indicators as GNP/head and forecast demand.
(b) Competitive advantage. This is principally dependent on prior experience in similar markets and having a cultural understanding.
(c) Risk. This involves an analysis of political stability, the possibility of government intervention and similar external influences.

Political Risk
is the risk that political action will affect the position and value of a company.
When a multinational company invests in another country, e.g. by setting up a subsidiary, it may face a political risk of action by that country's
government which restricts the multinational's freedom.

If a government tries to prevent the exploitation of its country by multinationals, it may take various measures, including the following:

- Quotas
- Tariffs
- Non-tariffs barriers. 1- (1+r)-n/r
- Restrictions
- Nationalisation
- Minimum Shareholding
Assessment of political risk
There are a large number of factors that can be taken into account when assessing political risk, for example:

- Government stability
- Political and business ethics
- Economic stability/inflation
- Degree of international indebtedness
- Financial infrastructure
- Level of import restrictions
- Remittance restrictions
- Evidence of expropriation
- Existence of special taxes and regulations on overseas investors, or investment incentives

In addition micro factors, factors only affecting the company or the industry in which it invests, may be more significant than macro factors,
particularly in companies such as hi-tech organisations.

Dealing with political risks

There are various strategies that multinational companies can adopt to limit the effects of political risk.

- Negotiation with host government

- Insurance
- Production Strategies
- Management Structure
Cultural risk
The following areas may be particularly important depending upon the location of the overseas investment:
(a) The cultures and practices of customers and consumers in individual markets
(b) The media and distribution systems in overseas markets
(c) The different ways of doing business in overseas markets
(d) The degree to which national cultural differences matter for the product concerned
(e) The degree to which a firm can use its own 'national culture' as a selling point

Factors influencing the choice of finance for an overseas subsidiary

In determining how an overseas investment should be financed, the following considerations need to be made:
(a) The local finance costs
(b) Taxation systems of the countries
(c) Any restrictions on dividend remittances
(d) The possibility of flexibility in repayments
(e) Access to capital
Igloo Ltd has identified the following investment projects.
to t1 t2
Immediate Time 1 Time 2
outlay
Tk. '000 Tk. '000 Tk. '000
Project A (100) (100) 303.6
Project B (50) (100) 218.9
Project C (200) 100 107.8
Project D (100) (50) 309.1
Project E (200) (50) 345.4

Requirements
Advise in the following circumstances.

(a) The company faces a perfect capital market, where the appropriate discount rate is 10%. All projects are independent and divisible. Which
projects should the firm accept?

(b) The company faces capital rationing at t0. There is only Tk. 225,000 of finance available. None of the projects can be delayed. Which projects
should the firm accept?

(c) The situation is as in part (b) above, except that you are now informed that projects A and B are mutually-exclusive. Which projects should now
be accepted?
Answer:
(a) No capital rationing
Accept all projects with NPV >= 0.

NPV
Tk '000
Project A 60
Project B 40
Project C – 20
Project D 110
Project E 40

Therefore accept A, B, D and E

(b) Single period capital rationing

Using benefit cost ratios (NPV/Tk.) = NPV/ Initial Investment
NPV/Tk. Rank
Project A = + 60 / 100 0.6 3
Project B = + 40 / 50 0.8 2
Project C = – 20 / 200 0.1 5
Project D = + 110 / 100 1.1 1
Project E = + 40 / 200 0.2 4

Tk. 225,000 available, therefore accept D, B, 3/4A.

(c) Mutually-exclusive investments

This problem is solved by trial and error, using the rankings from (b) above. The two alternative project combinations are as follows,

D, B, 37 1/2 % E: NPV (Tk. 000) = 110 + 40 + 15 = 165

D, A, 12 1/2 % E: NPV (Tk. 000) = 110 + 60 + 5 = 175

Therefore the better combination is D, A and 12 1/2% E.

Deshi Pictures Limited (DPL) is planning to produce a big budget film based on Liberation War 1971. The company’s Planning team has to
date spent BDT 1 Million researching the commercial elements and costs associated with producing and marketing the proposed film. The
findings of the research are given below:

BOX Office Projections Year 2 Year 3 Year 4

Movie Viewers 200,000 120,000 60,000

The company will receive BDT 300 per cinema viewer throughout the three years. This will reduce to BDT 250 in any year that the movie is
viewed by in excess of 100,000 viewers.

The movie will be made in year 1 of the proposal and released for viewing/sale/download for a three year period commencing in year 2

The company also forecasts that 15,000 DVDs of the movie will be sold in year 2 and will be reduced by 20% in each of subsequent two
years at an initial price of BDT 250 in year 2, reducing by BDT 50 per year thereafter in order to prolong sales.

In addition, it is anticipated that the movie may be downloaded at a cost to the purchaser of BDT 500 per download. The hosting website E-
B-Movie’s commission schedule is as follows:

Commission Schedule 1 – 25,000 25,001-100,000 100,001+

Commission % 15% 20% 25%

DPL expects that the following number of downloads will be sold in each year

Projected Downloads Year 2 Year 3 Year 4

Number of Downloads 50,000 150,000 20,000

The movie will incur the following promotional costs:

Projected Promotional Costs Year 2 Year 3 Year 4

Print Media 5,000,000 3,000,000 2,000,000
Premier Event 2,000,000 - -
DVD Posters 500,000 500,000 -
Internet Adverts 750,000 500,000 500,000
The cost of producing this movie will be as follows:

A famous director has been selected. This director will be paid BDT 5 Million immediately and a commission of 2.5% of all gross revenues
accruing to DPL. This commission is to be paid one year after the revenues accrue to DPL.

The cost of the movie cast will be:

Forecast Acting Costs Number Cost per Actor/Actress (BDT)

Lead 3 1,500,000

Support 20 200,000

Extras 250 25,000

Equipment costing BDT 15 Million will be purchased at the outset of the production. It will be resold when the movie is completed at the
end of year 1 for estimated sales proceeds of BDT 8 Million.

DPL’s Finance Director has asked you to use the company’s Weighted Average Cost of Capital (WACC) for the purpose of determining the
project’s Net Present Value. You have discerned the following information in relation to the company’s various sources of finance:

DPL’s Finance Structure Face Value (BDT Million)

Ordinary Shares (BDT 2 per Share) 15
20% Preference Shares (BDT 1 per Share) 5
8% Irredeemable Loan Stock 4

The ordinary shares are trading at BDT 3.50 ex dividend, whilst the preference shares are trading at BDT 2.40. The recently confirmed
preference dividend of BDT 0.20 per share has not been paid as yet. The loan stock is trading at par ex int.

The most recent dividend paid on DPL’s ordinary shares was BDT 0.40 per share. The average annual rate of growth of dividend in
ordinary shares is 8%, which is likely to continue for some years to come. DPL pays Income Tax at an effective rate of 19%.

Requirement: Advise Deshi Pictures Limited, based on strictly Net present value criteria, whether or not it should embark on the production
of the proposed movie.
Answer:

Workings - 01: Gross income accuring to the company

Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

1.1 Box Office Income

Number of viewer 200,000 120,000 60,000
Revenue per viewer 250 250 300
Income 50,000,000 30,000,000 18,000,000

1.2 DVD Sales Income

Number of DVD Sales 15,000 12,000 9,600
Revenue per DVD 250 200 150
Income 3,750,000 2,400,000 1,440,000

1.3 Download Income

Number of Download 50,000 150,000 20,000
Price per Download 500 500 500
Income 20% 25% 15%
20,000,000 56,250,000 8,500,000

Workings 02 - Variable payment to purchaser

Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Gross income accure to the company in the

previous year 73,750,000 88,650,000 27,940,000
Variable payment % 2.50% 2.50% 2.50%
Variable pay to producer 1,843,750 2,216,250 698,500
Ordinary Shares (ex div) 3.1 26,250,000 (7.5 X 3.50) 20.34% 50000 12.95%
Preference Shares (ex div) 3.2 11,000,000 (5 X 2.20) 9.09% 26.67% 2.42%
Irredeemable Loan Stock 3.3 4,000,000 6.48% 9.70% 0.63%
Weighted Average Cost of Capital 41,250,000 16%

3.1 Cost of equity (Gordon Growth Model)

P = D1/ K-g
K-g = D0 (1+g)/P
= [0.4 * ( 1 + .08) / 3.50] + 0.08 Value of stock, P = D1/ K-g
= 20.34% D1 = Do(1+g)
3.2 Cost of Preference shares P = 3.50
.20/ 2.2 = 9.09% g = 8%
K=?
3.3 Cost of Irredeemable bond
= 320 X ( 1 -.19/4000)
= 6.48%

Deshi Pictures Limited

Calculation of Net Present Value
Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Producer payment (5,000,000) - - (1,843,750) (2,216,250) (698,500)
Acting cost - (14,750,000) - - - -
Box office Income (W1) - - 50,000,000 30,000,000 18,000,000 -
DVD income - - 3,750,000 2,400,000 1,440,000 -
Net downloading income - - 20,000,000 56,250,000 8,500,000 -
Promotional costs - - (8,250,000) (4,000,000) (2,500,000) -
Equipment (15,000,000) 8,000,000 - - - -
Cash flow before tax (20,000,000) (6,750,000) 65,500,000 82,806,250 23,223,750 (698,500)
Tax @ 19% 3,800,000 1,282,500 (12,445,000) (15,733,188) (4,412,513) 132,715
Net annual cash flow (16,200,000) (5,467,500) 53,055,000 67,073,063 18,811,238 (565,785)
Discount factor @ 16% 1.0000 0.8621 0.7432 0.6407 0.5523 0.4761
Present value (16,200,000) (4,713,532) 39,430,476 42,973,711 10,389,446 (269,370)
Net present value 71,610,732
University of Economics has undertaken some legal and academic research at a cost of BDT 10,000 into the possibilities of
selling a Course on Econometrics. The University is unsure of the outcome of such a course, but feels that there is a 70%
chance of annual income of BDT 1,000,000 and a 30% chance of annual income of BDT 800,000.

Printing machinery would need to be bought at a cost of BDT 4,000,000 payable in two equal annual instalments, one
immediately and one in one year's time if the equipment had been operating correctly for a year. The equipment would be
depreciated on a straight line basis by BDT 399,000 per annum for ten years and then sold. Use would also be made of
some existing equipment which originally cost BDT 500,000, has a book value of BDT 20,000, and would cost BDT 600,000
to replace, though the firm is considering selling it for BDT 100,000.

Production and labour costs in the first year would amount to BDT 90,000 payable in one year's time, though the next nine
years' costs would fall to BDT 70,000 if demand were low in the first year.

Revenue would first be receivable in two years' time and for the following nine years. Fixed costs of BDT 150,000 per
annum would be reallocated to this Course.

Requirements:
Calculate the following
(i) Accounting rate of return by expressing Average annual pre-tax accounting profit on the project as a percentage of the
book value of the initial investment
(ii) Payback period.
(iii) Net present value of the project at the company's required rate of return of 10%.
(iv) Internal rate of return of the project.
(v) The sensitivity of your result in (iii) to the estimates of
- The required rate of return
Answer:
Calculation of Cash flows:
1. Accounting rate of return
Initial investments
Legal costs 10,000
Machinery 4,000,000
Existing equipment 20,000
4,030,000
Profit before tax
Total revenue 9,400,000
Total depreciation (4,020,000)
Total production and labour cost (720,000)
Total reallocated fixed costs (1,500,000)
Total profit 3,160,000
Average annual profit 316,000

ARR = Average Annual Profit / Initial Investment

= 316,000/ 4,030,000
= 7.84%

ii. Payback period

Time Descriptions Cash Flow Cumulative cash flow
0 First installment of machinery (2,000,000) (2,000,000)
0 Old machinery NRV (100,000) (2,100,000)
1 Second installment of machinery (2,000,000) (4,100,000)
1 Production & Labour costs (90,000) (4,190,000)
2 Net proceeds 868,000 (3,322,000)
3 Net proceeds 868,000 (2,454,000)
4 Net proceeds 868,000 (1,586,000)
5 Net proceeds 868,000 (718,000)
6 Net proceeds 868,000 150,000
7 Net proceeds 868,000 1,018,000
8 Net proceeds 868,000 1,886,000
9 Net proceeds 868,000 2,754,000
10 Net proceeds 868,000 3,622,000
11 Revenue 938,000 4,560,000

Payback period = (5 years +(718,000/868,000))

= 5.83 years
iii. NPV
Time Cash Flow Discount factor @ 10% Present value

0 (2,100,000) 1.000 (2,100,000)

1 (2,090,000) 0.909 (1,899,810)

2 - 10 868,000 5.235 4,543,980

10 10,000 0.386 3,860

11 938,000 0.350 328,300

NPV 876,330

iv. IRR
Time Cash Flow Discount factor @ 10% Present value Discount factor @ 16% Present value

0 (2,100,000) 1.000 (2,100,000) 1.000 (2,100,000)

1 (2,090,000) 0.909 (1,899,810) 0.862 (1,801,580)

2 - 10 868,000 5.235 4,543,980 3.971 3,446,828

10 10,000 0.386 3,860 0.227 2,270

11 938,000 0.350 328,300 0.195 182,910

NPV 876,330 (269,572)

By interpolation:
IRR = 10 % + [ 876,330 / ( 876,330 + 269,572)] X (16 - 10)
= 14.59% (Apprx.)
V. Sensitivity
Required rate of return
The project has an IRR of 14.59% ; therefore the required rate of return rise from 10% to 14.59% before investment decision would change. This
represents a rise of 4.59% points or (4.59/10) = 45.9%.
Tracking Limited (TL) manufactures and sells Global Positioning System (GPS) devices. Following favourable market
research that Cost BDT 500,000, Tracking Limited has developed a new GPS based Vehicle Tracking System (VTS). It intends
to set up a manufacturing facility in Bangladesh, although the board of TL had contemplated setting up in an overseas
country. The VTS project will have a life of four years

The selling price of the VTS will be BDT 10,000 per unit and sales in the first year to 31 December 2016 are expected to be
5,000 units per month, increasing by 4% pa thereafter. Relevant direct labour and materials costs are expected to be BDT
7,600 per unit and incremental fixed production costs are expected to be BDT 35 million pa. The selling price and costs are
stated in 31 December 2015 prices and are expected to increase at the rate of 2% & 7% per annum respectively. Research
and development costs to 31 December 2015 will amount to BDT 10 million.

Investment in working capital will be BDT 5 million on 31 December 2015 and this will increase in line with sales volumes
and inflation. Working capital will be fully recoverable on 31 December 2019.

Tracking will need to rent a factory for the life of the project. Annual rent of BDT 12 million will be payable in advance on 31
December each year and will not increase over the life of the project

Plant and machinery will cost BDT 250 million on 31 December 2015. The plant and machinery is expected to have a resale
value of BDT 50 million (in 31 December 2019 prices) at the end of the project. The plant and machinery will attract 20%
(reducing balance) capital allowances in the year of expenditure and in every subsequent year of ownership by the
company, except the final year. In the final year, the difference between the plant and machinery’s written down value for
tax purposes and its disposal proceeds will be treated by the company either:

(i) as an additional tax relief, if the disposal proceeds are less than the tax written down value, or
(ii) as a balancing charge, if the disposal proceeds are more than the tax written down value.

Corporation tax will be 35% pa for the foreseeable future and that tax flows arise in the same year as the cash flows which
gave rise to them.
The project will be financed from the company’s pool of funds and there will be no change in current gearing levels. An appropriate
weighted average cost of capital for the project is 14% pa.

TL’s directors are concerned that there are rumors in the industry of research by a rival company into a much cheaper alternative to the
GPS devices currently available. However, the rumors that the directors have heard suggest that this research will take another year to
complete and, if it is successful, it will be a further year before any new devices are operational.

Requirements:
i. Calculate, using money cash flows, the Net present value of the VTS project on 31 December 2015 and advise TL’s board as to
whether it should proceed.
ii. Calculate and comment upon the sensitivity of the project to a change in the annual rent of the factory and the weighted average
cost of capital.
iii. Assume now that the project had been financed entirely by debt and that this had caused the gearing of TL to change materially.
Describe how you would have appraised the project in such circumstances.
iv. If the board of TL decided to set up the manufacturing facility overseas, advise the board on how it might limit its effects of political
risk that could change the value of the project.

Answer:
Workings - 01: Contributions
Contribution = Tk. 10,000 - Tk. 7,600
= Tk. 2,400
Year Tk' 000
1 60000 X 2400 X 1.02 146,880
2 60000 X 2400 X 1.022 X 1.04 155,810
3 60000 X 2400 X 1.023 X 1.042 165,284
4 60000 X 2400 X 1.024 X 1.043 175,333

Workings - 2: Fixed costs

Year Tk' 000
1 35000 X 1.07 37,450
2 35000 X 1.072 40,072
3 35000 X 1.073 42,877
4 35000 X 1.074 45,878
Workings - 3: Capital Allowances
Year Cost / WDV Cap. Allowances @ 20% Tax @ 35%
0 250,000 50,000 17,500
1 200,000 40,000 14,000
2 160,000 32,000 11,200
3 128,000 25,600 8,960
4 102,400
4 (Sales) 50,000 52,400 18,340

Workings - 4: Working Capital

Year Requirement New investment/ (Divestment)
0 5,000 5,000
1 5,564 564
2 6,192 628
3 6,890 698
4 - (6,890)

Net Present Value of VTS Project

Details 0 1 2 3 4
Tk'000 Tk'000 Tk'000 Tk'000 Tk'000
Contribution 146,880 155,810 165,284 175,333
Fixed costs (37,450) (40,072) (42,877) (45,878)
Rent (12,000) (12,000) (12,000) (12,000)
Operating cash flow (12,000) 97,430 103,738 110,407 129,455
Tax 4,200 (34,101) (36,309) (38,642) (45,309)
Plant & Equipment (250,000) 50,000
Tax saved on capital allowance 17,500 14,000 11,200 8,960 18,340
working capital (5,000) (564) (628) (698) 6,890
Net cash flow (245,300) 76,765 78,001 80,027 159,376
Discount Factor 1.000 0.877 0.769 0.675 0.592
Present value @ 14% (245,300) 67,323 59,983 54,018 94,351
Net present value 30,374