SELECTED QUESTIONS AND GUIDE FROM PIKE AND NEALE CHAPTER 3

QUESTION 1
(Question 3 in CH 3 P &N)

A firm is considering the purchase of a machine which will cost Euro 20,000. it is estimated that
annual savings of Euro 5000 will result from the machine's installation, that the life of the
machine will be five years, and that its residual value will be Euro 1000.Assuming the required
rate of return to be 10 per cent , what action would you recommend?

Year Cash Flow PVIF/A PV

€ €

0 (20,000) 1 (20,000)

1-5 5,000 3.791 18,955

5 1,000 0.6209 621

NET PRESENT VALUE € (425)

QUESTION 2 A and B
(Question 6 in Ch 3 P &N)

(Note: This question involves calculating net present values at different rates showing how the
preference between projects can change as discount rates alter)

Calculate the net present value of projects A and B , assuming discount rates of 0 per cent,10
percent and 20 percent

A B

Initial Outlay (1,200) (1,200)

Cash receipts

Year 1 1,000 100

Year 2 500 600

Year 3 100 1,100

(i) Which is the superior project at each discount rate?

(ii) Why do they not all produce the same answer?

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(i)

At 0 % discount rate, simply add cash flows:

NPV (£)

Discount rate A B ADVICE

0% 400 600 B

(ii) At 10 per cent discount rate:

NPV (£)

Discount rate A B ADVICE

10% 197* 213 B

Working (Sample)

Year Cash Flow (€) PVIF@10% PV (€)

0 (1,200) 1 (1,200)

1 1,000 0.9091 909

2 500 0.8264 413

3 100 0.7513 75

NET PRESENT VALUE € 197*

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(iii) At 20 percent discount rate:

NPV (£)

Discount rate A B ADVICE

20% 38 (63) A

Part 2 (Comment)

At the 10% discount rate, project B is marginally superior, but at 20% only project A offers a
positive NPV. The changes in ranking between projects arise because they have very different cash
flow profiles. The correct approach is to decide upon the required rate of return and assess, which
project offers the higher NPV. At o% and 10% discount rates, project B is superior, but at 20%
only project A offers a positive NPV. The changes in ranking between projects arise because they
have very different cash flow profiles. The correct approach is to decide upon the required rate of
return and assess, which project offers the higher NPV.

QUESTION 3 Parts (i) to (iii) of BROSNAN PLC

(Parts of Question 7 Ch 3 of P &N)

Brosnan Plc generates cash flows of €5 million p.a. and has 10 million shares issued. Shareholders
require a 12 percent return.

REQUIRED

Value each share

(i) assuming all cash flows are distributed as dividend

(ii) assuming 50 percent distribution, and a growth rate of 7.5% p.a.

(iii) again assuming 50 percent distribution, but only 5% growth rate

(i) Assuming full distribution, and hence no growth: Value of equity = £5m/12% = £41.67m

Share price = £41.67m/10m = £4.167 or £4.2 per share

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(ii) With 50% distribution, dividends = £2.5m

With growth at 7.5%,

Value of equity = [£2.5m(1 + 7.5%)]/ (12% – 7.5%)

= £2.69m/1.045%

= £59.72

and thus £5.97, or £6 per share.

(iii) With 50% distribution, dividends again = £2.5m

With growth at 5.0%

Value of equity = [£2.5m(1 + 5%)] (12% – 5%) = £2.625m/7% = £37.5million or €3.75 per share

In the last case, profits being retained in the company would better have been distributed ! This is
because they are not resulting in enough growth

QUESTION 4 Part (iv) of BROSNAN PLC

(Part of Question 7 Ch 3 Pike and Neale)

Brosnan plc generates cash flows of £5 million p.a. after allowing for tax and depreciation. which
is used for investment. It has issued 10 million shares. Shareholders require 12 per cent return.

Value each share assuming that cash flows grow at 7.5 per cent for each of the first three future
years, then at 5 per cent thereafter. Assume 50% retention.

Assuming 50% retentions: Cash flows are:

Year Cash flows growing at 7.5%

Year PVIF at 12% PV

1 £2.5(1.075) = £2.69m 0.8929 £2.40m

2 £2.69X 1.075 = £2.89m 0.7972 £2.30m

3. £2.89X 1.075 = £3.11m 0.7118 £2.21m

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PV of years 1 – 3 = £6.91m

PV of years 4 – infinity inclusive:

[£3.11m(1.05)]/(12%–5%) = £46.65 Year 3 Value

£46.65 X 0.7118 (PVIF Year 3 @ 12%) = £33.20m

Therefore PV of equity = £40.11m i.e. £4 per share

QUESTION 5 LEYBURN PLC

(Question 9 Ch 3 Pike & Neale

Leyburn plc currently generates profits before tax of £10 million, and proposes to pay a dividend of
£4 million out of cash holdings to its shareholders. The rate of corporation tax is 30 per cent.
Recent dividend growth has averaged 8 per cent p.a. It is considering retaining an extra £1 million
in order to finance new strategic investment. This switch in dividend policy will be permanent, as
management believe that there will be a stream of highly attractive investments available over
the next few years, all offering returns of around 20 per cent after tax. Leyburn’s shares are
currently valued ‘cum-dividend’. Shareholders require a return of 14 per cent. Leyburn is wholly
equity-financed.

Required (a) Value the equity of Leyburn assuming no change in retention policy. (b) What is the
impact on the value of equity of adopting the higher level of retentions? (Assume the new payout
ratio will persist into the future.

(a) Value of equity now:

£4m (1 + 8%) = £4m X 1.08 = £4.32m

£4.32/ Ke -g = £4.32/14%-8% = £4.32/ 0.06 = £72m

Allowing for present dividend unpaid of £4m. Value of Leyburn = £76m

(b) Value of equity if more retentions:

This year’s earnings after tax = £10m (1 − 30%) = £7m

Retention rate now = 3/7 = 43%

Proposed retention rate = 4/7 = 57%

Growth rate: g = R X b

= 20% × 57% = 11.4%

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Value of equity

= Do (1+g)D + (k - g)

= 3(1.114)/ 14%–11.4%

= £3.342 / 0.026

= £128.5m

Adding to this £3 million present dividend unpaid

= £131.5m

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