FINANCIAL MANAGEMENT

CLASS (L-01 & L-02)

Prepared By: A.K.M Mesbahul
Karim FCA
Chapter – 02 : Investment appraisal
Recap of investment appraisal techniques
Payback Period = 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.

The maximum an investor would pay for a given set of cash flows (at his/her cost of capital)
Net present value 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
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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%
(d) The IRR of the project
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a)
Cumulative PV of
Time Cash flow (Tk.)’000 DF @ 15% Present value CF (Tk.)

1 70,000 0.869 60,830 60,830

2 70,000 0.756 52,920 113,820
3 80,000 0.658 52,640 166,460
4 100,000 0.572 57,200 223,660
5 300,000 0.497 149,100 372,760
6 220,000 0.432 95,040 467,800
7 300,000 0.376 112,800 580,600
Payback period = 6 years + [ (500,000 – 467,800) / 112,800 X 12 months
= 6 years 9 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
Initial
= 65,000/
ARR = 65,000/ 425,000 500,000
= 15.3% = 13%
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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 @ 15%

Time Cash flow DF @ 15% Present Value

0 (500,000) 1.000 (500,000)
1 70,000 0.820 57,400
2 70,000 0.672 47,040
3 80,000 0.551 44,080
4 100,000 0.451 45,100
5 100,000 0.370 37,000
6 470,000 0.302 141,940
NPV (23,696)

IRR = 12 (Lr)+ (33,850 (NPV Lr/ 33,850 NPV Lr + 127,440 NPV Hr ) X (22-12)
= 14 % (Appx.) 13.50% - 14.49%
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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
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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.
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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 Ltd 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 20% 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 30,000 35,000 40,000 Nil
Cash flow -30,000 -5000 -5000 40,000

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.
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Q. Changing working capital
A company plans to enter a 4 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 15000 17,325 18,150 19,965 0
Cash flow -15,000 -2,325 -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

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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.
Relevant cost of material
A new contract requires the use of 50 tonnes of metal ZX 81. This metal is used
regularly on all the firm's projects. At the moment there are in inventory 100 tonnes of
ZX 81, which were bought for Tk. 200 per tonne. The current purchase price is Tk. 210
per tonne, and the metal could be disposed of for net scrap proceeds of Tk.150 per
tonne.

With what cost should the new contract be charged for ZX 81 ?

The use of the material in inventory for the new contract means that moreZX 81 must
be brought for normal workings. The cost to the organizatiom is therefore the money
spent on purchase, no matter whether existing inventory or new inventory is used on
the contract.

Assuming that the additional purchases are made in the near future, the relevant cost
to the organization is current purchase price, is 50 tonnes X Tk. 210 = Tk. 10,500
Q: Relevant costs
A research project, which to date has cost the company Tk.150,000, is under review. If the project is allowed to proceed it
will be completed in approximately one year, when the results are to be sold to a government agency for Tk.300,000.
Shown below are the additional expenses which the managing director estimates will be necessary to complete the work:

Materials. This material has just been purchased at a cost of Tk.60,000. It is toxic; if not used in this project, it must be
disposed of at a cost of Tk. 5,000.

Labour. Skilled labour is hard to recruit. The workers concerned were transferred to the project from a production
department, and at a recent meeting the production manager claimed that if these people were returned to him they could
generate sales of Tk. 150,000 in the next year. The prime cost of these sales would be Tk. 100,000, including Tk. 40,000 for
the labour cost itself. The overhead absorbed into this production would amount to Tk. 20,000.

Research staff. It has already been decided that, when work on this project ceases, the research department will be closed.
Research wages for the year are Tk.60,000, and redundancy and severance pay has been estimated at Tk. 15,000 now, or
Tk. 35,000 in one year's time.

Equipment. The project utilises a special microscope which cost Tk. 18,000 three years ago. It has a residual value of Tk.
3,000 in another two years and a current disposal value of Tk. 8,000. If used in the project it is estimated that the disposal
value in one year's time will be Tk.6,000.

Share of general building services. The project is charged with Tk. 35,000 per annum to cover general building expenses.
Immediately the project is discontinued, the space occupied could be sub-let for an annual rental of Tk. 7,000.

Requirement
Advise the managing director as to whether the project should be allowed to proceed, explaining the reasons for the
treatment of each item.
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Costs and revenues of proceeding with the project.
Taka
(1) Costs to date of Tk. 150,000 are sunk costs, therefore ignore.

(2) Materials – purchase price of Tk. 60,000 is also sunk.

There is an opportunity benefit of the disposal costs saved. 5,000

(3) Labour cost – the direct cost of Tk. 40,000 will be incurred regardless of
whether the project is undertaken or not – and so is not relevant.
Opportunity cost of lost contribution = 150,000 – (100,000 – 40,000) (90,000)
The absorption of overheads is irrelevant – it is merely
an apportionment of existing costs which do not change.

(4) Research staff costs

Wages for the year (60,000)
Increase in redundancy pay (35,000 – 15,000) (20,000)

(5) Equipment
Deprival value if used in the project = disposal value (8,000)
Disposal proceeds in one year 6,000
(All book values and depreciation figures are irrelevant)

(6) General building services

Apportioned costs – irrelevant
Opportunity costs of rental forgone (7,000)
(174,000)
Sales value of project 300,000
Increased contribution from project 126,000

Advice. Proceed with the project.

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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.
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Q: Deprival value
Joe's car is not insured against theft.

He bought it two years ago for Tk. 2,000. A similar vehicle would now cost Tk. 1,000. He believes he could sell the vehicle for Tk. 1,000 after
spending Tk. 100 on advertising. The vehicle has two years of life remaining, and over this period he believes it will save him taxi fares with 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.
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Worked example: Tax Depreciation
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 30%. Tax Depreciation is available at 25% on a reducing balance basis. Show the TDAs and any balancing charge or allowance.

Solution
Year ended 31 Dec Tax WDV (WDV = written down value)
Tk.
20X1 10,000
TDA @ 25% -2,500

20X2 7,500
TDA @ 25% -1,875

20X3 5,625
Proceeds -2,000

Balancing allowance 3,625

Total reliefs = Tk. (2,500 + 1,875 + 3,625) = 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 (2,500) (1,875) (3,625)
Taxable (2,500) 5,125 3,375
Tax @ 30% 750* (1,538) (1,013)
* Tax saved, assuming sufficient profits exist elsewhere in the business to obtain relief from TDA as soon as possible.
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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 @ 30% (2,100) (2,100)
TDAs/Balancing allowance (2,500) (1,875) (3,625)

(2) Tax saved @ 30%* 750 563 1,088

Total tax (above) (1) + (2) 750 (1,538) (1,013)

* i.e. being able to deduct the TDA from profit saves tax @ 30%.

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 - (2,100) (2,100)
Asset purchase (10,000) - -
Scrap - - 2,000
Tax saved on TDAs 750 562 1,088
Net CF for discounting (9,250) 5,462 7,988
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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.
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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.
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Worked example: Replacement decision
A decision has to be made on replacement policy for vans. A van costs Tk.12,000. Vans can be replaced after 1,2, or 3 years. The
following additional information applies:

Interval between Trade-in Age at Maintenance cost

replacement allowance Year end paid at end of year
(years) (years)
1 9,000 Year of replacement Nil

2 7,500 1 2,000

3 7,000 2 3,000

Calculate the optimal replacement policy at a cost of capital of 15%. There are no maintenance costs if the van is replaced after one
year. Ignore taxation and inflation.

Solution
NPVs

1 year cycle NPV = (12,000) + 9,000/ 1.15 = Tk. (4,174)

2 year cycle NPV = (12,000) + (2,000)/ 1.15 + 7500 / 1.152 = Tk. (8,068)

3 year cycle NPV = (12,000) + (2,000)/ 1.15 + (3,000) / 1.152 + 7,000 / 1.153 = Tk. (11,405)

These costs are not comparable, because they refer to different time periods. The reason the one year cycle appears cheaper is
because it only reflects the cost of having a machine for one year, whereas the Tk. 11,405 for the 3 years cycle is the cost to the
business of keeping the resource for three years.
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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 Import quotas could be used to limit the quantities of goods that a subsidiary can buy from its parent company and import
for resale in its domestic markets.

Tariffs Import tariffs could make imports (such as from parent companies) more expensive and domestically produced goods
therefore more competitive.

Non-tariff Legal standards of safety or quality (non-tariff barriers) could be imposed on imported goods to prevent multinationals from
barriers selling goods through a subsidiary which have been banned as dangerous in other countries.

Restrictions A government could restrict the ability of foreign companies to buy domestic companies, especially those that operate in
politically sensitive industries such as defence contracting, communications, energy supply and so on.

Nationalisation A government could nationalise foreign-owned companies and their assets (with or without compensation to the parent
company).

Minimum A government could insist on a minimum shareholding in companies by residents. This would force a multinational to offer
shareholding some of the equity in a subsidiary to investors in the country where the subsidiary operates.
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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.

Negotiations with The aim of these negotiations is generally to obtain a concession agreement. This would cover matters such as the transfer of
host government capital, remittances and products, access to local finance, government intervention and taxation, and transfer pricing.

Insurance

May be necessary to strike a balance between contracting out to local sources (thus losing control) and producing directly
Production (which increases the investment and hence increases the potential loss). Alternatively it may be better to locate key parts of
strategies the production process or the distribution channels abroad. Control of patents is another possibility, since these can be
enforced internationally.

Management
structure Possible methods include joint ventures or ceding control to local investors and obtaining profits by a management contract.
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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 (a great deal for some consumer products, e.g.
washing machines where some countries prefer front-loading machines and others prefer top-loading machines, but less so for products
such as gas turbines)
(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, and any subsidies which may be available
(b) Taxation systems of the countries in which the subsidiary is operating. Different tax rates can favour borrowing in high tax regimes,
and no borrowing elsewhere. Tax-saving opportunities may be maximised by structuring the group and its subsidiaries in such a way as
to take the best advantage of the different local tax systems.
(c) Any restrictions on dividend remittances
(d) The possibility of flexibility in repayments which may arise from the parent/subsidiary relationship
(e) Access to capital. Obtaining capital from foreign markets may increase liquidity, lower costs and make it easier to maintain optimum
gearing.
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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?
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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