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##### BC plc is considering the introduction of a new breakfast cereal on which

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**Question**

BC plc is considering the introduction of a new breakfast cereal on which it has already spent ?50,000 on technical and feasibility studies. The new product will be a variation of our current breakfast cereal, Crunch Stuff, with the exception that it will contain sugar-coated roasted nuts. Consequently, it will be called Crunch Stuff 'n' Nuts.;The following information describes the new product;? Additional investment on new plant and equipment will amount to ?1.5 million. The sum will be financed using ?1 million 5-year bank loan at 6% rate of interest per annum, and ?0.5 million from retained earnings. This ratio of financing is in line with our company's current gearing ratio.;? Production and sales, estimated from market research are projected as follows;Year Units Produced and Sold;1 1,000,000;2 1,300,000;3 1,600,000;4 1,800,000;5 2,000,000;It is believed that about 10 percent of these projected sales will come from former Crunch Stuff customers who have switched to the new product.;? Sales price per unit: ?2.50 in years 1-3, rising to ?2.75 in year 4-5 in real terms.;? Variable costs, advertising and sales promotions: 50% of unit sales price in years 1-2, 52% in years 3-4, and 53% in year 5;? Annual fixed cost: ?50,000 per annum, rising at 2% per annum. 20% of annual fixed costs come from a re-allocation of the annual fixed cost from existing product lines.;? Working capital: an initial working capital investment of ?50,000 will be required just to get production started. For each year, the total investment in working capital will be equal to 10% of the value of sales.;? Depreciation method: use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years.;Other relevant information;? BC plc falls within 25% corporation tax band, and pays tax 12 months in arrears.;? BC plc currently has a nominal weighted average cost of capital of 15% after tax.;? The company appraises new project using nominal cash flows.;? Inflation rate in the UK over the next five year is project to be 2.5 percent per annum.;Required;Mr. Alexander concluded his email to you by requesting to respond to the following questions;a) How do sunk costs affect the determination of the cash flows associated with investment project?;b) Why do we focus on cash flows rather than accounting profits in making investment decisions?;c) Why should we be interested in incremental cash flows rather than total cash flows?;d) How should we calculate and treat working capital in investment appraisal?;e) How should we treat taxable depreciation allowance in investment appraisal?;f) Are financial charges and loan repayments relevant cash flows when using the net present value method of investment appraisal? Explain.;g) Why is it necessary for BC plc to finance the new product using both debt and equity capital in the same proportion as its current level of gearing?;h) How do we ensure consistency in the treatment of inflation in investment appraisal?;i) Derive the net cash flow of the new Crunch Stuff 'n' Nuts products. Show all workings and make clear any assumptions you make.;j) Is the new product financially viable on the basis of its net present value?;k) Using Excel, demonstrate and explain how you would evaluate the sensitivity of the project's NPV to changes in the estimates of unit sales price, annual sales volumes and variable costs.;l) What are the key merits and limitations of your analysis in (k) above?;BC plc is considering the introduction of a new breakfast cereal on;which it has already spent ??50,000 on technical and feasibility;studies. The new product will be a variation of our current breakfast;cereal, Crunch Stuff, with the exception that it will contain;sugar-coated roasted nuts. Consequently, it will be called Crunch Stuff;???n??? Nuts.;The following information describes the new product;Additional investment on new plant and equipment will amount to ??1.5;million. The sum will be financed using ??1 million 5-year bank loan at;6% rate of interest per annum, and ??0.5 million from retained earnings.;This ratio of financing is in line with our company???s current gearing;ratio.;Production and sales, estimated from market research are projected as;follows;Year Units Produced and Sold;1,000,000;1,300,000;1,600,000;1,800,000;2,000,000;It is believed that about 10 percent of these projected sales will come;from former Crunch Stuff customers who have switched to the new product.;Sales price per unit: ??2.50 in years 1-3, rising to ??2.75 in year 4-5;in real terms.;Variable costs, advertising and sales promotions: 50% of unit sales;price in years 1-2, 52% in years 3-4, and 53% in year 5;Annual fixed cost: ??50,000 per annum, rising at 2% per annum. 20% of;annual fixed costs come from a re-allocation of the annual fixed cost;from existing product lines.;Working capital: an initial working capital investment of ??50,000 will;be required just to get production started. For each year, the total;investment in working capital will be equal to 10% of the value of;sales.;Depreciation method: use the simplified straight-line method over five;years. It is assumed that the plant and equipment will have no salvage;value after five years.;Other relevant information;BC plc falls within 25% corporation tax band, and pays tax 12 months in;arrears.;BC plc currently has a nominal weighted average cost of capital of 15%;after tax.;The company appraises new project using nominal cash flows.;Inflation rate in the UK over the next five year is project to be 2.5;percent per annum.;Required;Mr. Alexander concluded his email to you by requesting to respond to the;following questions;How do sunk costs affect the determination of the cash flows associated;with investment project?;Why do we focus on cash flows rather than accounting profits in making;investment decisions?;Why should we be interested in incremental cash flows rather than total;cash flows?;How should we calculate and treat working capital in investment;appraisal?;How should we treat taxable depreciation allowance in investment;appraisal?;Are financial charges and loan repayments relevant cash flows when using;the net present value method of investment appraisal? Explain.;Why is it necessary for BC plc to finance the new product using both;debt and equity capital in the same proportion as its current level of;gearing?;How do we ensure consistency in the treatment of inflation in investment;appraisal?;Derive the net cash flow of the new Crunch Stuff ???n??? Nuts products.;Show all workings and make clear any assumptions you make.;Is the new product financially viable on the basis of its net present;value?;Using Excel, demonstrate and explain how you would evaluate the;sensitivity of the project???s NPV to changes in the estimates of unit;sales price, annual sales volumes and variable costs.;What are the key merits and limitations of your analysis in (k) above?;Q2;ABC plc is considering launching a takeover bid for XYZ plc. The two;companies are in the industry and have identical cost of equity capital;which is 12% after tax.;Below is an extract of some financial data on both companies;ABC plc XYZ plc;Earnings per share (eps) 50 pence 10 pence;Dividend per share (dps) 25 pence 5 pence;Price per share (pps) ??9.00 75 pence;Number of shares 5 million 3 million;XYZ plc is expected to produce growth in dividend per share of 5% per;annum to infinity with its current strategy and management. However, if;ABC plc acquired XYZ plc, the resulting synergy from the acquisition;would be such that the growth rate of dividend per share for XYZ plc can;be raised to 8%. In addition, ABC plc is also confident that it can;bootstrap the earnings of XYZ plc using its own higher P/E after the;acquisition of the company.;The transaction costs of the acquisition, which covers payment to the;investment banks and accountants advising ABC plc, are estimated to;amount to ??400,000.;Required;Calculate the total value of the synergy that would be created from the;combination of ABC plc and XYZ plc;using constant-growth dividend valuation model;using Price-earnings multiplier model;Comment on the limitations of the valuation models you have used in (a);above in the particular situation of this case scenario.;Explain the possible sources of synergy arising from the acquisition of;XYZ plc by ABC plc.;If ABC plc paid ??1.20 cash for each share of XYZ plc, what value of the;synergy calculated in (a ii) above would be available to the;shareholders of each company?;What are the advantages and disadvantages to ABC plc of paying cash to;acquire XYZ plc?;Using two recent cases, discuss the ways in which UK companies, which;have been the subject of unwanted (hostile or unfriendly) takeover bids;defended themselves from such bids.

Paper#26741 | Written in 18-Jul-2015

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