Question 1

A division in a company is undertaking a new project. The parent company is an export       driven manufacturing company. The division will be investing domestically in a repair based engineering project. The new project is less risky than the parent line of business.

The parent company has 25% debt financing and a resultant equity beta of 1.15. The debt  has a beta of 0.15. The project would be 40% debt funded, but the debt beta is estimated at

0.3.

The company faces a tax rate of 30%, the risk-free rate of interest is 4.5% and the stock market equity risk premium is 6%.

The project is not expected to exhibit the same level of risk as the parent company, the     parent cash flows are expected to fluctuate by 1.25 times economic activity, whereas the  project will only fluctuate by 0.95 times. With regard to operational gearing, the company’s fixed cost base is 55% of cash flows and the project has a 41% fixed cost base.

The project will need an initial investment of £31 million, and will last for six years. Of the £31 million, £28.5 million is for equipment that will be depreciated down to zero on a straight line  basis. Of the remainder of the initial investment, £1.5m is for shipping and installation            charges which will be capitalized; the remaining costs will be expensed straight away. The    company will wind down the project up at the end of year 6 and expects to sell the                 equipment for £6 million. The revenues from the project are expected to be £8 million in the  first year, rising to £10 million in the next year, after which they will grow at 15% for two         years, and then they will remain constant. Operating costs are forecast to be £3.5m in the     first year and the company is expecting these costs to rise by £0.25 million per annum           through to the end of the project. Initial working capital of £2.5 million is needed and the net  working capital requirements for each year after that are expected to be: £3.3m, £3.6m,         £3.9m, £3.2m, £2.8m, and then falling to zero at the end of the last year.

The new service will have a knock-on effect and increase revenues at other divisions within the company. These revenues are forecast to be in the order of £750,000 per annum for the duration of the project.

Required:                  Maximum Word Limit 1000 words

(a)        Calculate the equity beta for the repair based engineering project and then calculate the WACC for the project. (6 marks)

(b)        Lay out the cash flows and calculate the NPV. Should the company go ahead with the project? (8 marks)

(c)       Accounts receivable and accounts payable are accounting terms. Discuss whether they play any role in capital budgeting. (5 marks)

(d)       If a company is in a non-tax paying situation describe how this would affect its capital structure decision and its fixed asset investment decision, as far as capital budgeting is concerned. (6 marks)

(e)        Explain how the following are treated in capital budgeting: project interest payments,

opportunity costs, and project overheads . (5 marks) Total 30 marks

Question 2                Maximum Word Limit 1000 words

There are four zero coupon bonds that are priced at £95.45, £90.62, £85.74 and £81. 16, maturing in one, two, three and four years’ time.

(a)        Calculate the spot rates that will hold for years one, two, three and four. (5 marks)

(b)        From these spot rates, calculate the one-year forward rates that would start in years one, two and three. Calculate the two-year forward rate that starts in year two. (7 marks)

(c)       There is a coupon paying bond that has four years to redemption. The coupon is £6.50, what is the price of the bond? (5 marks)

(d)       Explain how an interest rate swap works and how they would benefit a company using them. (6 marks)

(e)        Explain what the duration of a bond is and calculate the duration of the following four-

year, 7% coupon bond. The spot interest rates for years 1, 2, 3 and 4 are 4.5%, 5%, 5.5% and 6%, respectively. (7 marks) Total 30 marks