Pinks Co. is a large company listed on a major stock exchange.
In recent years, the board of Pinks Co. has been criticised for
weak corporate governance and two of the company’s non-executive
directors have just resigned. A recent story in the financial media
has criticised the performance of Pinks Co. and claims that the
company is failing to satisfy the objectives of its key
stakeholders. Pinks Co. is appraising an investment project which
it hopes will boost its performance. The project will cost $20
million, payable in full at the start of the first year of
operation. The project life is expected to be four years. Forecast
sales volumes, selling price, variable cost and fixed costs are as
follows: Year 1 2 3 4 Sales (Units/ year) 300 000 410 000 525 000
220 000 Selling price ($/Unit) 125 130 140 120 Variable cost
($/Unit) 71 71 71 71 Fixed costs ($’000/year) 3000 3100 3200 3000
Selling price and cost information are in current price terms,
before applying selling price inflation of 5% per year, variable
cost inflation of 3.5% per year and fixed cost inflation of 6% per
year. Pinks Co. pays corporation tax of 26%, with the tax liability
being settled in the year in which it arises. The company can claim
tax- allowable depreciation on the full initial investment of $20
million on a 25% reducing balance basis. The investment project is
expected to have zero residual value at the end of four years.
Pinks Co has a nominal after-tax cost of capital of 12% and a real
after-tax cost of capital of 8%. The general rate of inflation is
expected to be 3.7% per year for the foreseeable future. Required:
a) Calculate: i) The nominal net present values of Pinks Co’s
investment project. ii) The discounted payback period of Pink Co”s
investment project. [10 marks] b) Comment on the financial
acceptability of Pink co’s investment project. [5 marks] c) The
directors of a company require that all investment projects should
be evaluated using either payback period or return on capital
employed (accounting rate of return). The target payback period of
the company is 2 years and the target return on capital employed. A
project is accepted if it satisfies either of the these investment
projects to be evaluated using net present value calculated over a
four-year planning period, ignoring inflation, any scrap value or
working capital recovery, with a balancing allowance being claimed
at the end of the fourth year of operation. Critically discuss the
director’s views on investment appraisal.
corporate finance