Fundament finance


I copied and paste the same information from the uploaded image. But the table information is better on the images sent as this does not support the table at all. Hoodoo Inc. Hoodoo Inc. is a growing company engaged in the manufacture of office equipment for the domestic US market. The company, whose earnings have increased from $20 million to $30 million over the last five years, maintains a steady policy of paying out 30 percent of its earnings as dividends. Hoodoo has common stock of $21⁄2 million in issue, consisting of $0.50 par value shares trading at a price earnings multiple of 9. The company also has $150 million of 61⁄2% bonds in issue, with six years remaining till maturity, and trading at a market price of $976 per $1000 nominal. Hoodoo is currently considering a proposal to manufacture a new type of machine for industrial use, specifically targeted at the Latin American market. The project is to be financed by a fresh issue of 61⁄2% bonds, but the company’s overall gearing will be maintained at the existing level. A trainee finance intern at Hoodoo has prepared a summary of the investment proposal over the project’s five-year time horizon. His workings are set out below: ($ 000’s) 2020 2021 2022 Revenue   48,000 96,000 Operating costs (-) 33,600 (-) 67,200 Overhead (-) 8,400 (-)16,800 Depreciation (-) 4,000 (-) 4,000 Interest (-) 245 (-) 2,000 (-) 2,000 Research & development (-) 3,605     Taxable Income (-) 3,850 0 6,000 Tax 0 0 (-) 645 After-tax income (-) 3,850 0 5,355 Capital expenditure (-) 20,000 Working capital (-) 5,000     Net cash flow (-) 28,850 0 5,355   2023-25 (per year) 110,000 (-) 77,000 (-)19,250 (-)  4,000 (-)  2,000 7,750 (-)  2,325 5,425 5,425 On the basis of the above cash flow projections, and using the coupon rate on bonds as the discount rate, the trainee finance intern has calculated the net present value of the project as follows: −28850 + 0 + 5355 + 5425 + 5425 + 5425 + 5425 = −$11461 thousand 1.065 1.0652 1.0653 1.0653 1.0654 1.0655 Since the net present value is negative, the project has been recommended for rejection. The trainee having finished his internship and left the firm, Hoodoo’s Chief Executive Officer has asked the company’s finance team to review what the trainee had done. On reviewing the proposal the finance team has ascertained the following information: o The figures assume sales of 6,000 machines in 2021, 12,000 in 2022, and 20,000 per year from 2023 to 2025. The unit price (in real terms) is expected to be $8,000 in the first two years of the project, then decline to $5,500 due to the entry of competition.       2 o Economies of scale would result in operating costs (excluding overheads) declining in line with the price reductions – these costs are therefore assumed as a constant 70% of sales revenues. o Overheads have been taken as 50 percent of direct labour, which is the company’s normal practice. However, an independent assessment suggests that the incremental overheads on account of the project are likely to be only 12 percent of revenue. o The company is allowed a 20 percent straight-line writing down allowance on new machinery. The machinery acquired for the project is expected to have a salvage value (at today’s prices) of $6 million at the end of five years. o R&D expenditure represents $3,500,000 spent in the year 2014. This figure has been corrected for 3% inflation from the date of the expenditure. This rate of inflation is expected to continue for the foreseeable future. o The company’s tax rate is 30%. Since taxable income is negative in 2015 and nil in 2016, the net loss of the first two years has been carried forward and deducted from taxable income to calculate the tax for 2017. Apart from the project under consideration, Hoodoo also has substantial taxable profits from its other activities. There is normally a lag of about a year before the company’s tax liabilities are assessed and paid. o Capital expenditure consists of $20 million for new machinery. The machinery is to be housed in an existing, fully-depreciated, factory building, for which no charge has been made. The factory building is expected to have a current market value of $7 million. o The average level of working capital investment in any year is estimated at 10% of the following year’s estimated revenue. o Since the project is to be financed entirely by a fresh issue of bonds, the net present value has been calculated at the coupon rate of 61⁄2%. The revenue and cost estimates can be assumed to be correct and reasonable. All the estimates are at current (2020) prices. Required: The Chief Executive Officer of Hoodoo plc has asked the finance team to prepare a report for the Board containing an amended investment appraisal of the project, with a full explanation of the methodologies used and their relative advantages, problems and limitations, taking into account the information provided above. She has also asked that any errors that might have been made by the trainee intern in estimating the cash flows for the investment appraisal should be fully explained in the report. Since not all the Board members are conversant with the net present value (NPV) technique she has asked that other more easily understandable appraisal techniques such as internal rate of return (IRR) and payback period (PBP) should also be used (in addition to NPV). Finally, she has asked for analytical comments on which of the following variables the project’s viability would be most sensitive to: ➢ Selling price of the machine ➢ Initial capital investment required (i.e. aggregate ‘year 0’ investment) ➢ Cost of capital 3 The following are the areas that are expected to be covered in a good report (not necessarily in any particular order): Calculation of an appropriate cost of capital, and discussion of what would be the appropriate cost of capital to use for evaluating the project in question. You should provide full explanations of the points that you make, using your own words. An amended investment appraisal of the project, with full and clear explanations of your reasons for including or excluding any of the information that has been provided. Based on your numerical evaluation of the project, a discussion of the relevant advantages, problems and limitations of the financial techniques used, followed by appropriate recommendations together with comments on other aspects the management team may also wish to consider. Your answer should provide explanations and calculations of specific alternative investment appraisal measures that could be used to address some of the limitations of popular techniques like IRR and PBP, while retaining their more useful features. The specific requirements of Hoodoo’s CEO should be addressed. Note: Ideally, your submission should be in the form of a report to the Board of Hoodoo Inc, with an appropriate spreadsheet/charts. The main report must be word-processed and word-counted, and the number of words clearly indicated on the cover sheet. The outer limit for the number of words is 3000 – reports which exceed this limit will be penalised. (There is no limit on what can be put into the appendices to the main report).

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