BAF-5-FOF Fundamentals of Finance – Additional Study Abroad Coursework assignment
LONDON SOUTH BANK UNIVERSITY
BAF-5-FOF Fundamentals of Finance
Additional Coursework Assignment for Study Abroad students
2017-18
The following criteria will be used in assessing this assignment:
1. Analytical & problem-solving skills (45%): Depth of analysis, and extent of
understanding of the analytical techniques used; breadth of knowledge
demonstrated; the relevance of the recommendations made and the extent to which
they relate theory to practice, etc.
2. Information technology skills (25%): The ability to use appropriate computer
software to prepare reports and process diverse financial information with a high
degree of numerical accuracy.
3. Written communication skills (20%): Report-writing ability - power of expression;
clarity of language and analytical logic; originality and effectiveness of structure and
4. Planning & organisational skills (10%): The manner in which the task was
approached, the extent of background reading done, etc.
Please note the following points:
This assignment lays emphasis on the demonstration of "soft" skills such as the ability
to use information technology creatively, communicate ideas and information clearly,
and work effectively as part of a team. These skills improve self-awareness, selfconfidence and employability. ‘Hard’ skills will be adequately tested in the closed
book examination, and are not given an unduly high weight as far as this assignment
is concerned; it is therefore possible for an assignment to earn a relatively low overall
mark even if it is numerically very accurate.
© Vijay Lee
Hoodoo Inc.
Hoodoo Inc. is a growing company engaged in the manufacture of office equipment for
the domestic US market. The company, whose earnings have increased from $20 million
to $30 million over the last five years, maintains a steady policy of paying out 30
percent of its earnings as dividends. Hoodoo has common stock of $2½ million in issue,
consisting of $0.50 par value shares trading at a price earnings multiple of 9. The
company also has $150 million of 6½% bonds in issue, with six years remaining till
maturity, and trading at a market price of $976 per $1000 nominal.
Hoodoo is currently considering a proposal to manufacture a new type of machine for
industrial use, specifically targeted at the Latin American market. The project is to be
financed by a fresh issue of 6½% bonds, but the company’s overall gearing will be
maintained at the existing level.
A trainee finance intern at Hoodoo has prepared a summary of the investment proposal
over the project’s five-year time horizon. His workings are set out below:
($ 000’s)
2015
2016
2017
2018-20
(per year)
Revenue
Operating costs
Overhead
Depreciation
Interest
Research & development
Taxable Income
Tax
After-tax income
Capital expenditure
Working capital
Net cash flow
(-) 245
(-) 3,605
(-) 3,850
0
(-) 3,850
(-) 20,000
(-) 5,000
(-) 28,850
48,000
(-) 33,600
(-) 8,400
(-) 4,000
(-) 2,000
96,000
(-) 67,200
(-)16,800
(-) 4,000
(-) 2,000
110,000
(-) 77,000
(-)19,250
(-) 4,000
(-) 2,000
0
0
0
6,000
(-) 645
5,355
7,750
(-) 2,325
5,425
0
5,355
5,425
On the basis of the above cash flow projections, and using the coupon rate on bonds as
the discount rate, the trainee finance intern has calculated the net present value of the
project as follows:
−28850 +
0
5355
5425
5425
5425
5425
+
+
+
+
+
= −$11461 thousand
2
3
3
4
1.065 1.065
1.065
1.065
1.065
1.0655
Since the net present value is negative, the project has been recommended for rejection.
The trainee having finished his internship and left the firm, Hoodoo’s Chief Executive
Officer has asked the company’s finance team to review what the trainee had done. On
reviewing the proposal the finance team has ascertained the following information:
o
The figures assume sales of 6,000 machines in 2016, 12,000 in 2017, and 20,000
per year from 2018 to 2020. The unit price (in real terms) is expected to be
$8,000 in the first two years of the project, then decline to $5,500 due to the
entry of competition.
2
o
Economies of scale would result in operating costs (excluding overheads)
declining in line with the price reductions - these costs are therefore assumed as
a constant 70% of sales revenues.
o
Overheads have been taken as 50 percent of direct labour, which is the
company’s normal practice. However, an independent assessment suggests that
the incremental overheads on account of the project are likely to be only 12
percent of revenue.
o
The company is allowed a 20 percent straight-line writing down allowance on
new machinery. The machinery acquired for the project is expected to have a
salvage value (at today’s prices) of $6 million at the end of five years.
o
R&D expenditure represents $3,500,000 spent in the year 2014. This figure has
been corrected for 3% inflation from the date of the expenditure. This rate of
inflation is expected to continue for the foreseeable future.
o
The company’s tax rate is 30%. Since taxable income is negative in 2015 and nil
in 2016, the net loss of the first two years has been carried forward and deducted
from taxable income to calculate the tax for 2017. Apart from the project under
consideration, Hoodoo also has substantial taxable profits from its other
activities. There is normally a lag of about a year before the company’s tax
liabilities are assessed and paid.
o
Capital expenditure consists of $20 million for new machinery. The machinery is
to be housed in an existing, fully-depreciated, factory building, for which no
charge has been made. The factory building is expected to have a current market
value of $7 million.
o
The average level of working capital investment in any year is estimated at 10%
of the following year’s estimated revenue.
o
Since the project is to be financed entirely by a fresh issue of bonds, the net
present value has been calculated at the coupon rate of 6½%.
The revenue and cost estimates can be assumed to be correct and reasonable. All the
estimates are at current (2015) prices.
Required:
The Chief Executive Officer of Hoodoo plc has asked the finance team to prepare a report
for the Board containing an amended investment appraisal of the project, with a full
explanation of the methodologies used and their relative advantages, problems and
limitations, taking into account the information provided above. She has also asked that
any errors that might have been made by the trainee intern in estimating the cash flows for
the investment appraisal should be fully explained in the report. Since not all the Board
members are conversant with the net present value (NPV) technique she has asked that
other more easily understandable appraisal techniques such as internal rate of return
(IRR) and payback period (PBP) should also be used (in addition to NPV). Finally, she has
asked for analytical comments on which of the following variables the project’s viability
would be most sensitive to:
➢ Selling price of the machine
➢ Initial capital investment required (i.e. aggregate ‘year 0’ investment)
➢ Cost of capital
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The following are the areas that are expected to be covered in a good report (not
necessarily in any particular order):
1. Calculation of an appropriate cost of capital, and discussion of what would be the
appropriate cost of capital to use for evaluating the project in question. You should
provide full explanations of the points that you make, using your own words.
2. An amended investment appraisal of the project, with full and clear explanations of
your reasons for including or excluding any of the information that has been provided.
3. Based on your numerical evaluation of the project, a discussion of the relevant
advantages, problems and limitations of the financial techniques used, followed by
appropriate recommendations together with comments on other aspects the
management team may also wish to consider. Your answer should provide explanations
and calculations of specific alternative investment appraisal measures that could be
used to address some of the limitations of popular techniques like IRR and PBP, while
retaining their more useful features. The specific requirements of Hoodoo’s CEO should
be addressed.
Note:
Ideally, your submission should be in the form of a report to the Board of Hoodoo Inc,
with an appropriate spreadsheet/charts. The main report must be word-processed and
word-counted, and the number of words clearly indicated on the cover sheet. The outer
limit for the number of words is 3000 - reports which exceed this limit will be penalised.
(There is no limit on what can be put into the appendices to the main report).
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