Question Tag: Cost of Capital

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FM – May 2016 – L3 – Q1 – Investment Appraisal Techniques

Calculation of Adjusted Present Value (APV) for a proposed project and analysis of its application in investment appraisal.

Question

Katam Pie has adopted a strategy of diversification into many different industries in order to reduce risk for the company’s shareholders. This has resulted in frequent changes in the company’s gearing level and widely fluctuating risks of individual investments. Presently, the company has a target debt-to-asset ratio i.e., D/(E + D) of 25%, an equity beta of 2.25, and a pre-tax cost of debt of 5%.

On January 1, 2016, Katam Plc with a year-end of December 31, is considering the purchase of a new machine costing N750million, which would enable it to diversify into a new line of business. The new business will generate sales of N522.50million in the first year, growing at 4.5% p.a. A constant contribution margin ratio of 40% can be expected throughout the 15-year life of the project. Incremental fixed cash costs will be N84.32million in the first year, growing by 5.4% p.a.

A regional development bank has offered a 10-year loan of 3% interest to finance 40% of the cost of the machine. The balance of 60% will be financed equally by a 10-year commercial loan (with annual interest of 5%) and a fresh round of equity. The issue cost on the commercial loan will be 1%, and the new equity will incur an issue cost of 3%. All issue costs are on the gross amount raised for the respective capital. Issue costs on debt are allowed for tax purposes.

A firm that is already in the business of the new project has a gearing ratio of 20% (debt to asset) and a cost of equity of 18.1%. Its corporate debt is risk-free.

The tax rate is 30% payable in the year the profit is made. Tax depreciation of 20% on cost is available on the new machine. Katam Pie has a weighted average cost of capital of 14% and a cost of equity of 17.5%. The risk-free rate is 4%, and the market risk premium is 7%.

You are required to:

Estimate the Adjusted Present Value (APV) and advise whether the project should be accepted? (21 Marks)
Explain:
i. The circumstances under which the use of APV is appropriate. (5 Marks)
ii. The major advantages and limitations of the use of the APV method. (4 Marks)

Answer

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Tags: Adjusted Present Value, Cost of Capital, Investment Appraisal, Risk Assessment, Tax Effects
Level: Level 3

Topic: Investment Appraisal Techniques

FM – Nov 2016 – L3 -SB – Q3 – Capital Gains Tax

Calculate EVA for Jack Limited and determine its market value added (MVA) based on provided assumptions.

Question

Jack Limited is a family-owned business that has grown strongly in the last 50 years. The key objective of the company is to maximise the family’s wealth through their shareholdings. Recently, the directors introduced value-based management, using Economic Value Added (EVA) as the index for measuring performance.

You are provided with the following financial information:

Statement of Profit or Loss and Other Comprehensive Income for the year ended December 31, 2015:

₦’million	2015
Operating profit	340.0
Finance charges	(115.0)
Profit before tax	225.0
Tax at 25%	(56.3)
Profit after tax	168.7

Notes

Notes	2015 (₦’m)	2014 (₦’m)
(i) Capital employed – from the Statement of Financial Position	6,285	6,185
(ii) Operating costs:
Depreciation	295	285
Provision for doubtful debts	10	2.5
Research and development	60	–
Other non-cash expenses	35	30
Marketing expenses	50	45
(iii) Economic depreciation is assessed to be ₦415 in 2015. Economic depreciation includes any appropriate amortisation adjustments. In previous years, it can be assumed that economic and accounting depreciation were the same.
(iv) Tax is the cash paid in the current year (₦45million) and an adjustment of ₦2.5million for deferred tax provisions. There was no deferred tax balance prior to 2015.
(v) The provision for doubtful debts was ₦22.5million on the 2015 Statement of Financial Position.
(vi) Research and development cost is not capitalised in the accounts. It relates to a new project that will be developed over five years and is expected to be of long-term benefit to the company. The first year of this project is 2015.
(vii) The company has been spending heavily on marketing each year to build its brand long term.
(viii) Estimated cost of capital of the company:
Equity	16%
Debt (pre-tax)	5%
(ix) Gearing (Debt/Equity) Ratio 1.5: 1

Required:
a. Calculate, showing all relevant workings, the Economic Value Added (EVA) for the year ended December 31, 2015. Make use of the adjusted opening capital employed. Comment on your result and make appropriate recommendations. (15 Marks)

b. Irrespective of your answer in (a) above, assume the company’s current EVA is ₦120million and that this will decline annually by 2% for the next ten years and then increase by 4% per annum in perpetuity. Assume the following for this part only:

Cost of equity 14%
WACC 10%

Calculate the market value added (MVA) by the company. Show all workings. (5 Marks)

Answer

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Tags: Cost of Capital, EVA, Financial Performance, MVA, Value-Based Management
Level: Level 3

Topic: Capital Gains Tax (CGT)
Series: NOV 2016

FM – Nov 2016 – L3 – SA – Q1 – Cost of Capital

Analyze a potential investment project, including the valuation of the firm’s equity and bonds, calculation of the risk-adjusted cost of capital, and project valuation with and without a buyout offer.

Question

Tinko Plc (TP) repairs and maintains heavy-duty trucks with workshops across Nigeria and parts of Africa. Below are extracts from its financial position:

Item	₦’million
Share capital (50k/share)	200
Reserves	320
Non-current liabilities	760
Current liabilities	60

The company’s Free Cash Flow to Equity (FCFE) is estimated at ₦153 million, with a perpetual growth rate of 2.5% annually. The equity shareholders require an 11% return.

The non-current liabilities consist of ₦1,000 nominal value bonds redeemable in 4 years at par with a 5.4% coupon. The credit spread is 80 basis points above the risk-free rate.

A project related to the “Graduates Back To Land (GBTL)” program is under consideration. The initial investment is ₦84 million, with estimated cash flows for four years. Details about the project include alternative scenarios for the program’s growth and a potential buyout offer of ₦100 million at the end of year one.

Required:
a. Calculate the current total market value of TP’s:
i. Equity (3 Marks)
ii. Bonds (4 Marks)

b. Calculate the risk-adjusted cost of capital required for the new project. (10 Marks)

c. Estimate the value of the project with and without the offer from FL (10 Marks)

d. State the assumptions made in your calculations. (3 Marks)

Answer

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Tags: Beta Estimation, Cost of Capital, Equity Valuation, Market Risks, Project Valuation
Level: Level 3

Topic: Cost of capital
Series: NOV 2016

FM – Nov 2014 – L3 – SA – Q1 – Investment Appraisal Techniques

Evaluate the financial feasibility of a cement production project using cost of capital, NPV, and MIRR methods.

Question

AK Plc is a company listed on the Nigerian Stock Exchange. It is involved in property development and sales.

The company currently imports more than 60% of its cement requirements. At a recent meeting of the board of directors, a decision was taken to establish a division for the production of cement in Ore, Ondo State. If the division is set up and the cement production goes ahead, output from the division will be sold to AK Plc and external customers at market price. For planning purposes, it has been decided that the financial viability of the project over the next five years should be determined.

The sum of N2 billion will be required. The sum of N500 million will be spent to acquire an existing factory considered suitable for the project. The balance of N1.5 billion will be applied for the procurement and installation of essential plant and equipment. Tax allowance can be claimed on plant and equipment at a uniform amount over 5 years with NIL scrap value.

A total of N20 million has been spent on various surveys (market, technical, financial, etc.) to date out of which N10 million has been paid. The balance of N10 million is due for payment at the end of year 1.

Production of cement for the next five years is projected as follows:

Year	Bags
1	500,000
2	600,000
3	650,000
4	800,000
5	700,000

A bag of cement sells currently for N2,000 in the open market. This price is expected to increase at the rate of 5% per annum. Variable cost is now N1,000 per bag. This will increase at 4% per annum. Fixed overhead costs will be N50 million at current prices but will rise by 8% per annum. Apportioned head office charges of N25 million at current prices will rise by 10% per annum. Fifty per cent (50%) of the total initial outlay of N2 billion is to be funded with a loan from a Federal Government Development Bank at a concessionary fixed interest rate of 8%, payable at the end of each year. Half of the loan will be repaid at the end of year 3 while the balance will be paid at the end of year 5. The project will require a working capital of 10% of annual revenue, and this should be available at the beginning of each year.

The company uses a current Weighted Average Cost of Capital (WACC) of 11% to appraise all capital projects. The asset beta of the company is 1.2, equity beta is 1.6, risk-free rate is 5%, while the market risk premium is 7%.

The Finance Director is of the view that it is not appropriate to use the existing WACC to appraise the new project. He has identified a listed company that currently produces cement and packaged fruit drinks. The company has the following financial statistics:

Equity beta: 1.82
Debt beta: 0.4
Debt/Equity ratio: 40%
60% of the market value of the company is attributed to cement production, while 40% of the value is attributed to the fruit drinks division.
The fruit drinks division has an equity beta of 0.8.

The new project is expected to move AK Plc to the target Debt/Equity ratio of 30%. Tax rate is 25% for the two companies and is paid in the year profit is made.

Required:

a. Compute the appropriate cost of capital that AK Plc should use to appraise the cement project and state why you consider this rate more appropriate than the existing WACC of 11%.

Note: Your final cost of capital should be rounded up to the nearest whole number. State any assumptions made. (12 Marks)

b. Compute the Net Present Value (NPV) and Modified Internal Rate of Return (MIRR) of the project, assuming a cost of capital of 13%.

(Work to the nearest N million). (16 Marks)

c. Recommend whether the project should be accepted or not, using both NPV and MIRR methods. (2 Marks)

Answer

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Tags: Cost of Capital, Modified Internal Rate of Return, Net Present Value, Project Appraisal, Risk Assessment, WACC
Level: Level 3

Topic: Investment Appraisal Techniques
Series: NOV 2014

FM – Nov 2016 – L3 – Q4 – International Financial Management

Evaluate a foreign investment decision for Gugi Plc, including cash flow, tax, and exchange rate considerations.

Question

Gugi Plc. is a highly successful manufacturing company operating in Nigeria. In addition to sales within Nigeria, the company also exports to a foreign country (with currency F$) along the ECOWAS sub-region. The export sales generate annual net cash inflow of ₦50,000,000.

Gugi Plc. is now considering whether to establish a factory in the foreign country and stop export from Nigeria to the country. The project is expected to cost F$1 billion, including F$200 million for working capital.

A suitable existing factory has been located, and production could commence immediately. A payment of F$950 million would be required immediately, with the remainder payable at the end of year one. The following additional information is available:

Details	Figures
Annual production and sales	110,000 units
Unit selling price	F$5,000
Unit variable cost	F$2,000
Unit royalty payable to Gugi Plc	₦300
Incremental annual cash fixed costs	F$50 million

Assume that the above cash items will remain constant throughout the expected life of the project of 4 years. At the end of year 4, it is estimated that the net realizable value of the non-current assets will be F$1.40 billion.

It is the policy of the company to remit the maximum funds possible to the parent (i.e., Gugi Plc.) at the end of each year. Assume that there are no legal complications to prevent this.

If the new factory is set up and export to the foreign country is stopped, it is expected that new export markets of a similar worth in North Africa could replace the existing exports. Production in Nigeria is at full capacity, and there are no plans for further capacity expansion.

Tax on the company’s profits is at a rate of 40% in both countries, payable one year in arrears. A double taxation agreement exists between Nigeria and the foreign country, and no double taxation is expected to arise. No withholding tax is levied on royalties payable from the foreign country to Nigeria.

Tax-allowable “depreciation” is at a rate of 25% on a straight-line basis on all non-current assets.

The Directors of Gugi Plc. believe that the appropriate risk-adjusted cost of capital of the project is 13%.

Annual inflation rates in Nigeria and the foreign country are currently 5.6% and 10%, respectively. These rates are expected to remain constant in the foreseeable future. The current spot exchange rate is F$1.60 = ₦1. You may assume that the exchange rate reflects the purchasing power parity theorem.

Required:

(a) Evaluate the proposed investment from the viewpoint of Gugi Plc.
Notes:

Show all workings and calculations to the nearest million.
State all reasonable assumptions. (18 Marks)

(b) State two further information and analysis that might be useful in evaluating this project. (2 Marks)

Answer

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Tags: Cost of Capital, Exchange Rate, Foreign Investment, Inflation, Net Present Value
Level: Level 3

Topic: International financial management

FM – Nov 2016 – L3 – Q1 – Investment Appraisal Techniques

Evaluate TP’s project considering current market values and assess the risk-adjusted cost of capital.

Question

Tinko Plc (TP) repairs and maintains heavy-duty trucks, with workshops in Nigeria and several other African countries. TP is considering an expansion project in response to the government’s recent policy aimed at encouraging mechanized farming through the “Graduates Back To Land (GBTL)” program, which will likely increase demand for heavy-duty machinery.

Below are extracts from the most recent Statement of Financial Position of TP:

Item	₦’million
Share capital	200
Reserves	320
Non-current liabilities	760
Current liabilities	60
Total	1,340

TP’s Free Cash Flows to Equity (FCFE) is currently estimated at ₦153 million, and it is expected to grow at 2.5% per annum indefinitely. The equity shareholders require a return of 11%.

The non-current liabilities consist entirely of bonds redeemable in four years at par with a coupon rate of 5.4%. The debt is rated BB, and the credit spread on BB-rated debt is 80 basis points above the risk-free rate.

In light of the GBTL program, TP is contemplating entry into the mechanized farming support industry through a four-year project, recognizing that after four years, competition may intensify significantly.

The project requires an initial investment of ₦84 million and is expected to generate the following after-tax cash flows:

Additional Information:

Scenario Adjustments:
- There is a 25% probability that the GBTL program will not grow as expected in the first year. If this occurs, the present value of the project’s cash flows over its four-year life will be 50% of the original estimates.
- If the GBTL program grows as expected in the first year, there is still a 20% probability that growth will slow in subsequent years, reducing the present value of cash flows to 40% of the original estimates for those years.
Sale Option: Feedwell Limited (FL) has offered ₦100 million to buy the project from TP at the start of the second year. TP is evaluating if this option adds strategic value to the project.
Abako Plc, a comparable company, operates primarily in non-agricultural services, similar to TP, and has an equity beta of 1.6. Abako derives approximately 80% of its revenues from services outside agriculture, with an asset beta of 0.80. Abako’s capital structure consists of 80 million shares trading at ₦4.50 per share and debt of ₦340 million.
The debt is trading at ₦1,050 per ₦1,000 with a zero debt beta.
Risk-free rate: 4%; Market risk premium: 6%; Corporate tax rate: 20%.

Requirements: a. Calculate TP’s current total market value of:

i. Equity (3 Marks)
ii. Bonds (4 Marks) b. Determine the risk-adjusted cost of capital for the new project (to the nearest percent) (10 Marks) c. Estimate the value of the project:
i. Without factoring in the potential strategic value or synergy from the project (5 Marks)
ii. With FL’s offer, assuming it reflects the market’s view of the project’s value (5 Marks) d. Clearly state the assumptions made in your calculations (3 Marks)

Answer

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Tags: Cost of Capital, Debt Valuation, Equity Valuation, Market Value, Project Valuation, Risk Adjustment
Level: Level 3

Topic: Investment Appraisal Techniques

FM – May 2024 – L3 – SC – Q6 – Financial Distress and Bankruptcy

Discuss economic exposure in currency risk management and calculate impact of USD strengthening on Linko Plc’s market value.

Question

(a) With respect to foreign currency risk management, explain economic exposure and discuss generally how a company can manage economic exposure. (8 Marks)

(b) Linko Plc is a UK-based company supplying medical equipment to the USA and Europe, while importing raw materials from the USA. It has net imports of 8 million dollars from the USA, which is expected to continue for the next six years. The company’s cost of capital is 10% per year. Assume cash flows occur at year-end and ignore taxation.

Required:
Assuming no change in the physical volume or dollar price of imports, estimate the impact on the expected market value of Linko Plc, if the market expects the dollar to strengthen by 4% per year against the pound. The current spot exchange rate (US$ per £1) is 1.9156 – 1.9210. (7 Marks)

Answer

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Tags: Cost of Capital, Currency Management, Economic Exposure, Foreign Exchange, Market Value Impact, Spot Rate
Level: Level 3

Topic: Financial Distress and Bankruptcy
Series: MAY 2024

FM – Nov 2018 – L3 – Q5 – Capital Budgeting under Uncertainty

Analyze whether replacing a machine after three or four years is more beneficial based on economic costs and tax implications.

Question

Kuku Plc. had a need for a machine. After four years of purchase, the machine will no longer be capable of efficient working at the level of use by the company. The company typically replaces machines every four years. The production manager has noted that in the fourth year, the machine will require additional maintenance to maintain normal efficiency. This raises the question of whether the machine should be replaced after three years instead of four years, as per company practice.

Relevant information is as follows:

(i) A new machine will cost N240,000. If retained for four years, it will have zero scrap value at the end. If retained for three years, it will have an estimated disposal value of N30,000. The machine qualifies for capital allowance of 20% on a reducing balance basis each year, except in the last year. In the final year, if the disposal proceeds are less than the tax written-down value, the difference will be an additional tax relief.

The machine is assumed to be bought and disposed of on the last day of the company’s accounting year.

(ii) The company tax rate is 30%, payable on the last day of the relevant accounting year.

(iii) Maintenance costs are covered by the supplier in the first year. In the second and third years, maintenance costs average N30,000 annually. In the fourth year, they increase to N60,000. Maintenance costs are tax-allowable and payable on the first day of the accounting year.

(iv) The company’s cost of capital is 15%.

Required:

a. Prepare calculations to determine whether it is economically beneficial to replace the machine after three years or four years. (12 Marks)

b. Discuss two additional factors that could influence the company’s replacement decision, including any potential weaknesses in the decision criteria. (3 Marks)

Answer

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Tags: Capital Allowance, Cost of Capital, Disposal Value, Economic Benefit, Machine Replacement, Maintenance Costs, Tax implications
Level: Level 3

Topic: Capital Budgeting under Uncertainty

FM – Nov 2022 – L3 – Q3 – Financing Decisions and Capital Markets

Evaluate the financing structure and calculate required return, WACC, and factors influencing beta.

Question

Zakai (ZK) Plc is a listed company that owns and operates a large number of farms throughout the country. A variety of crops are grown.

Financing Structure:
The following is an extract from the statement of financial position of ZK Plc as at 30 September 2021:

The ordinary shares were quoted at ₦3 per share ex div on 30 September 2021. The beta of ZK Plc’s equity shares is 0.8; the annual yield on treasury bills is 5%, and financial markets expect an average annual return of 15% on the market index.

The market price per preference share was ₦0.90 ex div on 30 September 2021. Loan stock interest is paid annually in arrears and is allowable for tax at 30%. The loan stock was priced at ₦100.57 ex interest per ₦100 nominal on 30 September 2021. Loan stock is redeemable on 30 September 2022.

Assume that taxation is payable at the end of the year in which taxable profits arise.

A New Project:
Difficult trading conditions have caused ZK Plc to decide to convert a number of its farms into camping sites with effect from the 2022 holiday season. Providing the necessary facilities for campers will require major investment, and this will be financed by a new issue of loan stock. The returns on the new campsite business are likely to have a very low correlation with those of the existing farming business.

Required:

a. Using the capital asset pricing model, calculate the required rate of return on equity of ZK Plc as at 30 September 2021. Ignore any impact from the new campsite project. (3 Marks)

b. Briefly explain the implications of a beta of less than 1, such as that for ZK Plc. (2 Marks)

c. Calculate the weighted average cost of capital (WACC) of ZK Plc as at 30 September 2021 (use your calculation in answer to requirement (a) above for the cost of equity). Ignore any impact from the new campsite project. (10 Marks)

d. Without further calculations, identify and explain the factors that may change ZK Plc’s equity beta during the year ending 30 September 2022. (5 Marks)

(Total 20 Marks)

Answer

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Tags: Beta Analysis, CAPM, Cost of Capital, Equity Valuation, Financing Structure, Investment decisions
Level: Level 3

Topic: Financing Decisions and Capital Markets
Series: NOV 2022

FM – Nov 2022 – L3 – Q2 – Financing Decisions and Capital Markets

Evaluating financing options (rights issue vs convertible loans) for Balama Plc's expansion.

Question

Balama Plc. (Balama) is a listed manufacturer of dairy products. In recent years, the company has experienced only a modest level of growth, but following the recent retirement of the chief executive, his replacement is keen to expand Balama’s operations.

The board of directors has recently agreed to support a proposal by the new chief executive that the company purchase new manufacturing equipment to enable it to expand its range of dairy products. The new equipment will cost N50 million, and the company is seeking to raise new finance to fund the expenditure in full. However, the board of directors is undecided as to how the new finance is to be raised. The directors are considering either a 1 for 5 rights issue at a price of N2.50 per share with a theoretical ex-rights price of N2.92 or a convertible loan of N50 million.

The loan will be secured against the company’s freehold land and buildings. The company’s share is presently quoted at a price of N3.00 per share.

Required:

a. Explain the terms ‘rights issue’ and ‘convertible loans’. (3 Marks)

b. Explain how the ‘theoretical ex-rights’ price of N2.92 is calculated and why the actual price might be different. Show your workings. (4 Marks)

c. Prepare a report for the board of directors that fully evaluates the two potential methods of financing the company’s expansion plans. (13 Marks)

(Total 20 Marks)

Answer

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Tags: Convertible Loans, Cost of Capital, Equity Financing, Financial strategy, Financing Expansion, Loan financing, Rights Issue, Shareholder Value
Level: Level 3

Topic: Financing Decisions and Capital Markets
Series: NOV 2022

FM – May 2016 – L3 – Q1 – Investment Appraisal Techniques

Calculation of Adjusted Present Value (APV) for a proposed project and analysis of its application in investment appraisal.

Question

A firm that is already in the business of the new project has a gearing ratio of 20% (debt to asset) and a cost of equity of 18.1%. Its corporate debt is risk-free.

You are required to:

Estimate the Adjusted Present Value (APV) and advise whether the project should be accepted? (21 Marks)
Explain:
i. The circumstances under which the use of APV is appropriate. (5 Marks)
ii. The major advantages and limitations of the use of the APV method. (4 Marks)

Answer

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Tags: Adjusted Present Value, Cost of Capital, Investment Appraisal, Risk Assessment, Tax Effects
Level: Level 3

Topic: Investment Appraisal Techniques

FM – Nov 2016 – L3 -SB – Q3 – Capital Gains Tax

Calculate EVA for Jack Limited and determine its market value added (MVA) based on provided assumptions.

Question

You are provided with the following financial information:

Statement of Profit or Loss and Other Comprehensive Income for the year ended December 31, 2015:

₦’million	2015
Operating profit	340.0
Finance charges	(115.0)
Profit before tax	225.0
Tax at 25%	(56.3)
Profit after tax	168.7

Notes

Notes	2015 (₦’m)	2014 (₦’m)
(i) Capital employed – from the Statement of Financial Position	6,285	6,185
(ii) Operating costs:
Depreciation	295	285
Provision for doubtful debts	10	2.5
Research and development	60	–
Other non-cash expenses	35	30
Marketing expenses	50	45
(iii) Economic depreciation is assessed to be ₦415 in 2015. Economic depreciation includes any appropriate amortisation adjustments. In previous years, it can be assumed that economic and accounting depreciation were the same.
(iv) Tax is the cash paid in the current year (₦45million) and an adjustment of ₦2.5million for deferred tax provisions. There was no deferred tax balance prior to 2015.
(v) The provision for doubtful debts was ₦22.5million on the 2015 Statement of Financial Position.
(vi) Research and development cost is not capitalised in the accounts. It relates to a new project that will be developed over five years and is expected to be of long-term benefit to the company. The first year of this project is 2015.
(vii) The company has been spending heavily on marketing each year to build its brand long term.
(viii) Estimated cost of capital of the company:
Equity	16%
Debt (pre-tax)	5%
(ix) Gearing (Debt/Equity) Ratio 1.5: 1

Cost of equity 14%
WACC 10%

Calculate the market value added (MVA) by the company. Show all workings. (5 Marks)

Answer

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Tags: Cost of Capital, EVA, Financial Performance, MVA, Value-Based Management
Level: Level 3

Topic: Capital Gains Tax (CGT)
Series: NOV 2016

FM – Nov 2016 – L3 – SA – Q1 – Cost of Capital

Analyze a potential investment project, including the valuation of the firm’s equity and bonds, calculation of the risk-adjusted cost of capital, and project valuation with and without a buyout offer.

Question

Tinko Plc (TP) repairs and maintains heavy-duty trucks with workshops across Nigeria and parts of Africa. Below are extracts from its financial position:

Item	₦’million
Share capital (50k/share)	200
Reserves	320
Non-current liabilities	760
Current liabilities	60

The company’s Free Cash Flow to Equity (FCFE) is estimated at ₦153 million, with a perpetual growth rate of 2.5% annually. The equity shareholders require an 11% return.

The non-current liabilities consist of ₦1,000 nominal value bonds redeemable in 4 years at par with a 5.4% coupon. The credit spread is 80 basis points above the risk-free rate.

Required:
a. Calculate the current total market value of TP’s:
i. Equity (3 Marks)
ii. Bonds (4 Marks)

b. Calculate the risk-adjusted cost of capital required for the new project. (10 Marks)

c. Estimate the value of the project with and without the offer from FL (10 Marks)

d. State the assumptions made in your calculations. (3 Marks)

Answer

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Tags: Beta Estimation, Cost of Capital, Equity Valuation, Market Risks, Project Valuation
Level: Level 3

Topic: Cost of capital
Series: NOV 2016

FM – Nov 2014 – L3 – SA – Q1 – Investment Appraisal Techniques

Evaluate the financial feasibility of a cement production project using cost of capital, NPV, and MIRR methods.

Question

AK Plc is a company listed on the Nigerian Stock Exchange. It is involved in property development and sales.

Production of cement for the next five years is projected as follows:

Year	Bags
1	500,000
2	600,000
3	650,000
4	800,000
5	700,000

Equity beta: 1.82
Debt beta: 0.4
Debt/Equity ratio: 40%
60% of the market value of the company is attributed to cement production, while 40% of the value is attributed to the fruit drinks division.
The fruit drinks division has an equity beta of 0.8.

The new project is expected to move AK Plc to the target Debt/Equity ratio of 30%. Tax rate is 25% for the two companies and is paid in the year profit is made.

Required:

a. Compute the appropriate cost of capital that AK Plc should use to appraise the cement project and state why you consider this rate more appropriate than the existing WACC of 11%.

Note: Your final cost of capital should be rounded up to the nearest whole number. State any assumptions made. (12 Marks)

b. Compute the Net Present Value (NPV) and Modified Internal Rate of Return (MIRR) of the project, assuming a cost of capital of 13%.

(Work to the nearest N million). (16 Marks)

c. Recommend whether the project should be accepted or not, using both NPV and MIRR methods. (2 Marks)

Answer

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Tags: Cost of Capital, Modified Internal Rate of Return, Net Present Value, Project Appraisal, Risk Assessment, WACC
Level: Level 3

Topic: Investment Appraisal Techniques
Series: NOV 2014

FM – Nov 2016 – L3 – Q4 – International Financial Management

Evaluate a foreign investment decision for Gugi Plc, including cash flow, tax, and exchange rate considerations.

Question

Details	Figures
Annual production and sales	110,000 units
Unit selling price	F$5,000
Unit variable cost	F$2,000
Unit royalty payable to Gugi Plc	₦300
Incremental annual cash fixed costs	F$50 million

It is the policy of the company to remit the maximum funds possible to the parent (i.e., Gugi Plc.) at the end of each year. Assume that there are no legal complications to prevent this.

Tax-allowable “depreciation” is at a rate of 25% on a straight-line basis on all non-current assets.

The Directors of Gugi Plc. believe that the appropriate risk-adjusted cost of capital of the project is 13%.

Required:

(a) Evaluate the proposed investment from the viewpoint of Gugi Plc.
Notes:

Show all workings and calculations to the nearest million.
State all reasonable assumptions. (18 Marks)

(b) State two further information and analysis that might be useful in evaluating this project. (2 Marks)

Answer

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Tags: Cost of Capital, Exchange Rate, Foreign Investment, Inflation, Net Present Value
Level: Level 3

Topic: International financial management

FM – Nov 2016 – L3 – Q1 – Investment Appraisal Techniques

Evaluate TP’s project considering current market values and assess the risk-adjusted cost of capital.

Question

Below are extracts from the most recent Statement of Financial Position of TP:

Item	₦’million
Share capital	200
Reserves	320
Non-current liabilities	760
Current liabilities	60
Total	1,340

TP’s Free Cash Flows to Equity (FCFE) is currently estimated at ₦153 million, and it is expected to grow at 2.5% per annum indefinitely. The equity shareholders require a return of 11%.

The project requires an initial investment of ₦84 million and is expected to generate the following after-tax cash flows:

Additional Information:

Scenario Adjustments:
- There is a 25% probability that the GBTL program will not grow as expected in the first year. If this occurs, the present value of the project’s cash flows over its four-year life will be 50% of the original estimates.
- If the GBTL program grows as expected in the first year, there is still a 20% probability that growth will slow in subsequent years, reducing the present value of cash flows to 40% of the original estimates for those years.
Sale Option: Feedwell Limited (FL) has offered ₦100 million to buy the project from TP at the start of the second year. TP is evaluating if this option adds strategic value to the project.
Abako Plc, a comparable company, operates primarily in non-agricultural services, similar to TP, and has an equity beta of 1.6. Abako derives approximately 80% of its revenues from services outside agriculture, with an asset beta of 0.80. Abako’s capital structure consists of 80 million shares trading at ₦4.50 per share and debt of ₦340 million.
The debt is trading at ₦1,050 per ₦1,000 with a zero debt beta.
Risk-free rate: 4%; Market risk premium: 6%; Corporate tax rate: 20%.

Requirements: a. Calculate TP’s current total market value of:

i. Equity (3 Marks)
ii. Bonds (4 Marks) b. Determine the risk-adjusted cost of capital for the new project (to the nearest percent) (10 Marks) c. Estimate the value of the project:
i. Without factoring in the potential strategic value or synergy from the project (5 Marks)
ii. With FL’s offer, assuming it reflects the market’s view of the project’s value (5 Marks) d. Clearly state the assumptions made in your calculations (3 Marks)

Answer

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Tags: Cost of Capital, Debt Valuation, Equity Valuation, Market Value, Project Valuation, Risk Adjustment
Level: Level 3

Topic: Investment Appraisal Techniques

FM – May 2024 – L3 – SC – Q6 – Financial Distress and Bankruptcy

Discuss economic exposure in currency risk management and calculate impact of USD strengthening on Linko Plc’s market value.

Question

(a) With respect to foreign currency risk management, explain economic exposure and discuss generally how a company can manage economic exposure. (8 Marks)

Answer

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Tags: Cost of Capital, Currency Management, Economic Exposure, Foreign Exchange, Market Value Impact, Spot Rate
Level: Level 3

Topic: Financial Distress and Bankruptcy
Series: MAY 2024

FM – Nov 2018 – L3 – Q5 – Capital Budgeting under Uncertainty

Analyze whether replacing a machine after three or four years is more beneficial based on economic costs and tax implications.

Question

Relevant information is as follows:

The machine is assumed to be bought and disposed of on the last day of the company’s accounting year.

(ii) The company tax rate is 30%, payable on the last day of the relevant accounting year.

(iv) The company’s cost of capital is 15%.

Required:

a. Prepare calculations to determine whether it is economically beneficial to replace the machine after three years or four years. (12 Marks)

b. Discuss two additional factors that could influence the company’s replacement decision, including any potential weaknesses in the decision criteria. (3 Marks)

Answer

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Tags: Capital Allowance, Cost of Capital, Disposal Value, Economic Benefit, Machine Replacement, Maintenance Costs, Tax implications
Level: Level 3

Topic: Capital Budgeting under Uncertainty

FM – Nov 2022 – L3 – Q3 – Financing Decisions and Capital Markets

Evaluate the financing structure and calculate required return, WACC, and factors influencing beta.

Question

Zakai (ZK) Plc is a listed company that owns and operates a large number of farms throughout the country. A variety of crops are grown.

Financing Structure:
The following is an extract from the statement of financial position of ZK Plc as at 30 September 2021:

Assume that taxation is payable at the end of the year in which taxable profits arise.

Required:

a. Using the capital asset pricing model, calculate the required rate of return on equity of ZK Plc as at 30 September 2021. Ignore any impact from the new campsite project. (3 Marks)

b. Briefly explain the implications of a beta of less than 1, such as that for ZK Plc. (2 Marks)

d. Without further calculations, identify and explain the factors that may change ZK Plc’s equity beta during the year ending 30 September 2022. (5 Marks)

(Total 20 Marks)

Answer

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Tags: Beta Analysis, CAPM, Cost of Capital, Equity Valuation, Financing Structure, Investment decisions
Level: Level 3

Topic: Financing Decisions and Capital Markets
Series: NOV 2022

FM – Nov 2022 – L3 – Q2 – Financing Decisions and Capital Markets

Evaluating financing options (rights issue vs convertible loans) for Balama Plc's expansion.

Question

The loan will be secured against the company’s freehold land and buildings. The company’s share is presently quoted at a price of N3.00 per share.

Required:

a. Explain the terms ‘rights issue’ and ‘convertible loans’. (3 Marks)

b. Explain how the ‘theoretical ex-rights’ price of N2.92 is calculated and why the actual price might be different. Show your workings. (4 Marks)

c. Prepare a report for the board of directors that fully evaluates the two potential methods of financing the company’s expansion plans. (13 Marks)

(Total 20 Marks)

Answer

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Tags: Convertible Loans, Cost of Capital, Equity Financing, Financial strategy, Financing Expansion, Loan financing, Rights Issue, Shareholder Value
Level: Level 3

Topic: Financing Decisions and Capital Markets
Series: NOV 2022

Question Tag: Cost of Capital

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FM – May 2016 – L3 – Q1 – Investment Appraisal Techniques

Calculation of Adjusted Present Value (APV) for a proposed project and analysis of its application in investment appraisal.

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FM – Nov 2016 – L3 -SB – Q3 – Capital Gains Tax

Calculate EVA for Jack Limited and determine its market value added (MVA) based on provided assumptions.

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FM – Nov 2016 – L3 – SA – Q1 – Cost of Capital

Analyze a potential investment project, including the valuation of the firm’s equity and bonds, calculation of the risk-adjusted cost of capital, and project valuation with and without a buyout offer.

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FM – Nov 2014 – L3 – SA – Q1 – Investment Appraisal Techniques

Evaluate the financial feasibility of a cement production project using cost of capital, NPV, and MIRR methods.

Required:

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FM – Nov 2016 – L3 – Q4 – International Financial Management

Evaluate a foreign investment decision for Gugi Plc, including cash flow, tax, and exchange rate considerations.

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FM – Nov 2016 – L3 – Q1 – Investment Appraisal Techniques

Evaluate TP’s project considering current market values and assess the risk-adjusted cost of capital.

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FM – May 2024 – L3 – SC – Q6 – Financial Distress and Bankruptcy

Discuss economic exposure in currency risk management and calculate impact of USD strengthening on Linko Plc’s market value.

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FM – Nov 2018 – L3 – Q5 – Capital Budgeting under Uncertainty

Analyze whether replacing a machine after three or four years is more beneficial based on economic costs and tax implications.

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FM – Nov 2022 – L3 – Q3 – Financing Decisions and Capital Markets

Evaluate the financing structure and calculate required return, WACC, and factors influencing beta.

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FM – Nov 2022 – L3 – Q2 – Financing Decisions and Capital Markets

Evaluating financing options (rights issue vs convertible loans) for Balama Plc's expansion.

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FM – May 2016 – L3 – Q1 – Investment Appraisal Techniques

Calculation of Adjusted Present Value (APV) for a proposed project and analysis of its application in investment appraisal.

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FM – Nov 2016 – L3 -SB – Q3 – Capital Gains Tax

Calculate EVA for Jack Limited and determine its market value added (MVA) based on provided assumptions.

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FM – Nov 2016 – L3 – SA – Q1 – Cost of Capital

Analyze a potential investment project, including the valuation of the firm’s equity and bonds, calculation of the risk-adjusted cost of capital, and project valuation with and without a buyout offer.

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FM – Nov 2014 – L3 – SA – Q1 – Investment Appraisal Techniques

Evaluate the financial feasibility of a cement production project using cost of capital, NPV, and MIRR methods.

Required:

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FM – Nov 2016 – L3 – Q4 – International Financial Management

Evaluate a foreign investment decision for Gugi Plc, including cash flow, tax, and exchange rate considerations.

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FM – Nov 2016 – L3 – Q1 – Investment Appraisal Techniques

Evaluate TP’s project considering current market values and assess the risk-adjusted cost of capital.

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FM – May 2024 – L3 – SC – Q6 – Financial Distress and Bankruptcy

Discuss economic exposure in currency risk management and calculate impact of USD strengthening on Linko Plc’s market value.

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FM – Nov 2018 – L3 – Q5 – Capital Budgeting under Uncertainty

Analyze whether replacing a machine after three or four years is more beneficial based on economic costs and tax implications.

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FM – Nov 2022 – L3 – Q3 – Financing Decisions and Capital Markets

Evaluate the financing structure and calculate required return, WACC, and factors influencing beta.

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FM – Nov 2022 – L3 – Q2 – Financing Decisions and Capital Markets

Evaluating financing options (rights issue vs convertible loans) for Balama Plc's expansion.

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