Advanced financial management revision question and answer

(a) Goldstar Manufacturing Limited is evaluating an investment opportunity that would require an outlay of sh.100 million. The annual net cash inflows are estimated to vary according to economic conditions.


The firm‟s required rate of return is 14 percent. The project has an expected life of six years.

Required:
Compute the expected net present value (NPV) of the proposed investment.

(b) Pwani Limited is planning advertising campaigns in three different market areas. The estimates of probability of success and associated additional profits in each of the three markets are provided below:


Required:

(i) Compute the expected value and standard deviation of profits resulting from advertising campaigns in each of the market areas.

(ii) Rank the three markets according to riskiness using the coefficient of variation.

(c) Rugongo Ltd. is an ungeared company operating in the processed food industry. The company is planning to take over Sauce Ltd. but is unsure on how to value its net assets. Rugongo Ltd.‟s analysts have assembled the following information:

1. Sauce Ltd.‟s balance sheet as at 30 September 2003


In its most recent trading period ended 30 September 2003, Sauce Ltd.‟s sales were Sh.500,000,000, but after operating costs and other expenses including a depreciation charge of Sh.20,000,000, its profit after tax was Sh.20,000,000. This figure includes an extraordinary item (sale of property) of Sh.5,000,000. The full years dividend was Sh.5,000,000.

Sauce Ltd. has recently followed a policy of increasing dividends 12% per annum. Its shareholders require a return of 17%.

The price earnings ratio of Rugongo Ltd. is 14 times and that of Sauce Ltd. is 8 times.

More efficient utilization of Sauce Ltd.‟s assets could generate operating savings of Sh.5,000,000 per annumafter tax.

Required:
(i) Current market value of Sauce Ltd.‟s share.
(ii) Explain why the market value might differ from the book value
(iii) A company experiencing ordinary growth, has high liquidity and much unused borrowing capacity.
(iv) The value of Sauce Ltd. using the discounted cash flow method.
ANSWER

The ranking is from the lowest risk to highest risk. The lower the coefficient of variation, the lower the risk and vice versa.

(ii) Book values are historical while market values are determined on the basis of demand and supply depending on existing market conditions.
(iii) Rate of return on equity (ROE)

(iv) For valuation purposes, use the free cash flows.

Cash flows         =        E.A.T – exceptional items + accounting depreciation

=        20M – 5M + 20M = 35M

Accounting depreciation = economic depreciation which represents cost of replacing assets.

∴ free cash flows = Cash flows – Economic depreciation + savings

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