BFA503 | Financial Management | Purpose Of Computing The NPV

Question 1

Home Guardian has recently completed a $200,000, two-year study on its new pest control device. It can go into production for an initial investment in equipment of $5 million. The equipment will be depreciated straight line over the useful life of 5 years to a value of zero. The fully depreciated equipment is expected to sell for $1,200,000 at the end of its useful life. The project also requires investment in land value of $300,000 which is expected to have a realisable value of $500,000 at the end of the project. Investment of $400,000 in current assets will be recovered at the termination of the project. The marketing department has estimated that 200,000 units of its new device could be sold annually over the next five years at a price of $10 each. Fixed costs of $500,000 per annum will be incurred.

The firm is an ongoing profitable business and pays taxes at a 30% rate in the year of income. All capital gains will also be taxed at a rate of 30%. The company uses a 12% discount rate on the new project. Using the NPV approach, advise the firm whether the project should be undertaken.

Question 2
HRE Mining Limited’s (HRE) is considering a major gold exploration project in South Sudan. Costs of financing have been declining recently causing the finance department to consider sourcing capital through debt and equity issues. The company’s bonds will mature in six years with a total face value of $100 million, paying a half yearly coupon rate of 10% per annum. The yield on the bonds is 15% per annum. The market value for the company’s preference share is $4.75 per unit while the ordinary share is currently worth $1.85 per unit. The preference share pays a dividend of $0.4 per share. The beta coefficient for the ordinary share is 1.4. No issue costs will be incurred by the company. The market risk premium is estimated to be 12% per annum and the risk-free rate is 4% per annum. The company is subject to a 30% corporate tax rate and intends to issue 200,000 preference shares and 5,000,000 ordinary shares. HRE’s current balance sheet shows the following information for bonds and shares:

$ Million

Preference shares 3

Ordinary shares 15

Bonds 100

a. Outline the necessary steps required to estimate the company’s weighted average cost of capital.

b. Calculate the after-tax cost of each of the company’s current financing sources.

c. Using the information provided, calculate the market values for the financing sources for HRE.

d. Using the information from b.) and c.) calculate HRE’s after-tax weighted average cost of capital.

e. The company’s finance department has confirmed that the proposed project will generate an IRR of 15% per year. Discuss whether or not the project should be undertaken.

Question 3

Mid-Western Mining Ltd is considering short term financing for its working capital requirement. You are invited to provide a discussion on the three key factors that the company should consider in selecting different sources of short term financing. Briefly discuss these factors and illustrate with an appropriate example where possible.

Q1. Calculate the NPV of the project and provide a critical analysis of the company’s future with the proposed construction of a new plant.
Applies correct principles and calculations, substantiated with workings or diagrams in order to correctly calculate the NPV. There are no errors in calculations. Provides a precise critical analysis of the company’s proposed future.
Applies correct principles and calculations, substantiated with workings or diagrams in order to correctly calculate the NPV. Workings may contain s few minor errors. Provides a detailed critical analysis of the company’s proposed future.
Applies correct principles and calculations, substantiated with
workings or diagrams in order to correctly calculate the NPV. Workings contain some minor errors. Provides a critical analysis of the company’s proposed future. May contain limited detail and reference to examples from the case.
Applies understanding of relevant principles, correctly calculates the NPV. Workings contain some major errors. Attempts to provide a critical analysis of the company’s proposed future.
No understanding of relevant principles, incorrectly calculates the NPV. Workings contain major errors. Failed to provide a critical analysis of the company’s proposed future.

Q2. Complete calculation as required. Discuss your recommendations for the potential project and support with relevant calculations.
Applies correct principles and calculations, substantiated with workings or diagrams in order to arrive at the right answer. There are no errors in calculations.
Applies correct principles and calculations, substantiated with workings or diagrams in order to arrive at the right answer, shows workings but contains few minor errors.
Applies correct principles and calculations, substantiated with workings or diagrams in order to arrive at the right answer, shows workings but contains some minor errors.
Applies understanding of relevant principles, shows workings but contains some major errors.
No understanding of relevant principles, no workings and contains major errors.

Q3. Discuss the factors relevant to the given scenario and illustrate with an appropriate example where possible.
Principles are applied in the appropriate manner to arrive at the correct answer. The use of relevant principles and example shows creativity and imagination.
Discussion reflects detailed understanding of relevant principles. Uses an example to illustrate the discussion.
Discussion reflects good understanding of relevant principles. Makes use of an example to attempt to illustrate but relevance is unclear or inaccurate.
Discussion reflects basic understanding of relevant principles. Limited or no use of relevant example.
Discussion reflects no understanding of relevant principles. No use of relevant example.