Technology Investment Analysis

This assignment presents a case study where a company is considering purchasing new technology. Students must calculate the initial outflow, after-tax salvage value, working capital recovery, terminal value, and ultimately the Net Present Value (NPV) of the project. Based on the calculated NPV, students are required to provide a recommendation whether the company should invest in the technology or not, justifying their answer.

KOI
Trimester 2, 2017
FIN700 – Financial Management
ASSIGNMENT– GROUP
Due date: Submit to your Tutor by the start of your Tutorial on
Monday, 11 September, 2017 or on Tuesday, 12 September, 2017.
Keep a soft copy in case of misadventure.
Penalties for late lodgment, as per the Subject Outline, will be strictly applied.
This Assignment consists of 4 problems, each involving
calculations, and in some cases recommendations.
You are required to complete this Assignment in Groups of 2 or 3 or 4 people.
Groups of 1 or more than 4 persons will incur a penalty of 5 marks out of 30%.
All members of the Group should come from the same Tutorial class. You may
consult and discuss the Assignment topic with others, but you must write up your
answers yourselves. Penalties for copying and plagiarism are severe.
You should follow the following typing conventions:
 Answers to be typed, in the space provided after each question
 If additional pages are required, use the blank pages at the end.
 Times New Roman font (at minimum , 12 pitch), 1.5 line spacing; and
 Left and right margins to be at least 2.5 cm from the edge of the page.
Research, Referencing and Submission
You should quote any references used at the end of each question.
Use Harvard referencing! See http://en.wikipedia.org/wiki/Harvard_referencing
As this is a calculations problem, there is no need to submit via TURNITIN.
Do not submit this page. Submit page 2 onwards, with KOI Group Assignment Cover Page.
Marking Guide
The Assignment will be scored out of 100%, in line with the rubric in the
Subject Outline. This mark will be converted to a score out of 30%.
Dr Mervyn Fiedler, Subject Co-ordinator, FIN 700. 11 August, 2017.
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______________________________________________________________________
***NOTE:When submitting Assignment, please submit from this page onwards,
with a KOI Group Assignment cover page in front.***
Trimester T217
FIN700
GROUP ASSIGNMENT
Students: Please complete the following before submitting for marking.
Group members
Student No. Student Name Percentage Contribution to Assignment Signature
1. ………………………………………………………………………………………………
2. ………………………………………………………………………………………………
3. ………………………………………………………………………………………………
4. ………………………………………………………………………………………………
Tutor: Please circle one name: Dr Mervyn Fiedler; Ms Ruhina Karim;
Mr Masoud Ahmadi-Pirshahid; Mr Nishith Panthi.
Tutorial Day …………………………………………………and Time ……………………….
This Assignment consists of four questions. All questions must be answered.
Please answer all questions in the spaces provided after each question.
Two extra pages are included at the end of the Assignment. If more pages are
required, please copy (or extend) page 14.
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QUESTION `1. [6 + 8 = 14 Marks.]
a) This is a two period certainty model problem.
Assume that William Brown has a sole income from Bobcat Ltd in which he owns
12% of the ordinary share capital.
In its financial year 2016-17 just ended, Bobcat Ltd reported net profits after tax
of $600,000, and announced its net profits after tax expectation for the next
financial year, 2017-18, to be 25% higher than this year’s figure. The company
operates with a dividend payout ratio of 70%, which it plans to continue, and will
pay the annual dividend for 2016-17 in mid-August, 2017, and the dividend for
2017-18 in mid-August, 2018.
In mid-August, 2018, Jack wishes to spend $100,000, which will include the cost
of a new car.. How much can he consume in mid-August, 2017 if the capital
market offers an interest rate of 9% per year?
Answer:
Financials for 2016-17
Net profits after tax = $600,000
Dividends paid by company = $600,000 * 70% = $420,000
Dividends received by William = 420,000 * 12% = $50,400
Financials for 2017-18
Net profits after tax = $600,000 * 1.25 = $750,000
Dividends paid by company = $750,000 * 70% = $525,000
Dividends received by William = 525,000 * 12% = $63,000
PV of dividends to be received in 2017-18 = 63000 / (1.09)^1
= $57,798.17
Total income in 2016-17 available = $50,400 + $57,798.17
= $108,198.2
Since William needs $100,000 for purchase of car in 2017-18, he can consume
income above $100,000.
Income that can be consumed by Williams in Aug, 2017 = $108,198.2 - $100,000
= $8,198.2
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QUESTION 1 continued.
b) This question relates to the valuation of shares.
Big Ideas Ltd has just paid a dividend of $1.20 a share. Investors require a 12%
per annum return on investments such as Big Ideas. What would a share in Big
Ideas Ltd be expected to sell for today (August, 2017) if the dividend is expected
to increase by 20% in August, 2018, 15% in August, 2019, 10% in August, 2020
and thereafter by 5 per cent a year forever, from August, 2021 onwards?
Answer:
Current dividend = $1.2
Dividend in 2018 = 1.2 * 1.2 = $1.44
Dividend in 2019 = 1.44 * 1.15 = $1.65
Dividend in 2020 = 1.65* 1.1 = $1.82
Dividend in 2021 = 1.82*1.05 = $1.91
P0 = D1 / (r-g)
Price of share at the end of 2020 = 1.91 / (0.12 – 0.05)
= $27.32
Year Cash flow Discount rate PV
2018 $1.44 12% $1.28
2019 $1.65 12% $1.31
2020 $1.82 12% $1.29
2020 $27.32 12% $17.36
Total Present Value $21.24
Hence the price of share of Big Ideas Ltd. in August 2017 is $21.24
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QUESTION 2. [(4 + 6) + (4 + 4 + 4 + 4 + 4) = 30 Marks]
a) This question relates to the time value of money and deferred perpetuities.
Colin Greenway attended Bunyip High School in the 1970s. After leaving school,
Colin became a successful entrepreneur and is now very wealthy. He wishes to
establish a perpetual scholarship fund which will provide $10,000 a year, payable
to five high performing students at Bunyip High School each year in Year 12, that
is, $50,000 a year, starting in early 2020. It is now early 2017. The High School
Principal believes that the required funds can be invested at 5 per cent a year in
perpetuity.
i) What is the present value in early 2017 of the whole income stream, and
thus the amount which Colin must contribute to establish the fund?
Answer:
Present value of perpetuity (PVP) = C / r
PVP2020 = (10000*5) / 0.05
= $1,000,000
Now we discount the above perpetuity to today’s date.
PVP2017 = $1,000,000 / (1.05^3)
= $863,837.59
Thus Colin must contribute $863,837.59 in 2017 to establish the fund.
ii) The High School Principal, while most appreciative of Colin’s great
generosity, mentions that fees at Bunyip High are rising on average by 3
per cent every year because of inflation, and that in several years,
$10,000 will not be enough to keep a student in year 12 for a whole year.
Colin decides that he will increase the amount to establish the fund so as
to provide for increases in the scholarship amount by 3 per cent a year in
perpetuity, the first increase occurring in early 2021. How much extra
(above the amount calculated in i) above, will Colin need to contribute in
early 2017 so as to provide for these inflation increases forever?
[HINT: Consider a formula similar to the dividend growth model.]
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Answer:
PV of cash flow occurring in 20202017 = 50000 / (1.05^3)
= $43,191.88
PVP2021 = C (1+g)/ (r-g)
= 50000*1.03 / (0.05 – 0.03)
= $2,575,000
PVP2017 = $2,575,000 / (1.05^4)
= $2,118,459
Total PV of cash flows in 2017 = $2,118,459 + $43191.88
= $2,161,651
Difference in amount to be contributed by Colin = $2,161,651 - $863,837.59
= $1,297.813.15
QUESTION 2 continued.
b) This question relates to loan repayments and loan terms.
Ron and Robin Reid wish to borrow $540,000 to buy a home. The loan from
Biggles Bank requires equal monthly repayments over 20 years, and carries.an
interest rate of 7.8% per annum, compounded monthly. The first repayment is
due at the end of the first month.
You are required to calculate:
i) the effective annual interest rate on the above loan.
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Answer:
Effective annual interest = [1+(i/n)]^n-1
I = 7.8% , n = 20 years
Effective annual interest = [1+(7.8 / 20)]^20 – 1
= 8.085%
ii) the amount of the monthly repayment (consisting of interest and principal
repayment components) if the same amount is to be repaid every month
over the 20 year period of the loan.
Answer:
Monthly installment = Pi / [1-(1+i)^-n]
P = $540,000
I = 7.8% / 12 = 0.0065
N = 20*12 = 240 periods
Hence monthly repayment = 540000 * 0.0065 / [1-(1+0.0065)^-240 ]
= $4,449.79
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iii) the amount of $X, if - instead of the above - Biggles Bank agrees that Ron
and Robin will repay the loan by paying the bank $3,300 per month for
the first 12 months, then $3,750 a month for the next 12 months, and after
that $X per month for the balance of the 20 year term.
Answer:
PV of installment of $3300 for 1 year = 3300 * [1-(1+0.0065)^-12 ]
0.0065
= 3300 * 11.51
= $37976.44
PV of installment of $3750 for 2nd year = 3750 * [1-(1+0.0065)^-12 ]
0.0065
= $43,155.04
PV of 2nd year installment in current year = $43,155.04 / (1.0065)^12
= $39,926.96
Total payment made in 24 months = $37976.44 + $39,926.96
= $77903.4
Total repayment to be made to the bank = 4449.79*240
= $10,67,950
Amount remaining to be paid after 24 months = $10,67,950 - $77903.4
= $990,046.2
Let the monthly installment to be paid be X to repay $990,046.2 in 18 years
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PV of installment of X for 18 years = (X * [1-(1+0.0065)^-216 ] ) / (1.0065^24)
0.0065
$990,046.2 = (X * [1-(1+0.0065)^-216 ] ) / (1.0065^24)
0.0065
X = $9,980.86
Hence, $9,980.86 is to be paid per month for the rest of the loan term.
QUESTION 2 b) continued.
iv) how long (in years and months) it would take to repay the loan if,
alternatively, Ron and Robin decide to repay $2,500 per month, with the
first repayment again being at the end of the first month after taking the
loan, and continuing until the loan was repaid.
Answer:
It is not possible for Ron and Robin to pay an installment of $2500 per month because the
loan installment cannot be less than the monthly installment on loan. The monthly
interest amounts to $3510. Hence, we cannot calculate the time taken to repay the loan in
the above case, it is an impossible situation.
v) under option iv) above, the amount of the final repayment. [NOTE:
Towards the end of the loan repayment period, after the final full monthly
instalment of $2,500 is paid, a lesser amount is likely to be outstanding.
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That amount, plus interest to the end of the following month, is the final
loan repayment amount.]
Answer:
Again this question depends on the above part iv, hence, it is not possible to calculate the
value.
QUESTION 3. [(2 + 3 + 3 + 4 + 3 + 3) + (6 + 2 + 4) = 30 marks]
a) This question relates to alternative investment choice techniques
Stanley Livingstone is considering the following cash flows for two mutually
exclusive projects.
Year Cash Flows, Investment X ($) Cash Flows, Investment Y ($)
0 -40,000 -40,000
1 12,000 18,000
2 18,000 18,000
3 27,000 18,000
You are required to answer the following questions:
i) If the cash flows after year 0 occur evenly over each year, what is the
payback period for each project, and on this basis, which project would
you prefer?
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IN THE REMAINING PARTS, ASSUME THAT ALL CASH FLOWS
OCCUR AT THE END OF EACH YEAR.
ii) Would the payback periods then be any different to your answer in i)? If
so, what would the payback periods be?
QUESTION 3 a) continued.
iii) Sketch freehand the net present value (NPV) profiles for each investment
on the same graph. Label both axes and the NPV profile for each
investment.
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iv) Calculate the internal rate of return (IRR) for each project and indicate
them on the graph. [NOTE: It is satisfactory if the approximate IRR is
calculated for Investment X by trial and error, and stated as a percentage
correct to the nearer whole number. The IRR for Investment Y should be
calculated as a percentage exactly, correct to 1 decimal place.]
QUESTION 3 a) continued.
v) Calculate the exact crossover point and indicate it on the above graph.
vi) State which of the investments you would prefer, depending on the
required rate of return (i.e., depending on the discount rate).
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b) This question relates to the valuation of bonds.
Bradley White, a retired school teacher, has two 6 per cent per annum $100,000
Australian Government bonds that mature on 15 August, 2020 and 15 August,
2023 respectively. At the date of the last half-yearly interest payment, viz., 15
February, 2017, both bonds were selling at par.
Since then, interest yields on bonds have risen by 2% per annum, compounded
half-yearly. Bradley now intends to sell the bonds and put a deposit on a
suburban townhouse.
i) Calculate the price he will receive from each bond if he sells on 15
August, 2017 at the new yield, immediately after receiving the interest
payments due that day.
QUESTION 3 b) continued.
ii) Explain the relative price movements in the two bonds, as evidenced in
your answer to i) above.
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iii) Suppose that Bradley defers buying the bonds for 84 days, that is until 7
November, 2017. How much will he pay for each bond on that day?
[NOTE: Between the bond interest due dates from mid-August to mid-
February is 184 days, during which time interest accrues on a compound
basis.]
QUESTION 4. [24 + 2 = 26 marks].
This question relates to capital budgeting.
Perth Projects Ltd is considering the purchase of new technology costing $600,000,
which it will fully finance with a fixed interest loan of 10% per annum, with the principal
repaid at the end of 4 years.
The new technology will permit the company to reduce its to reduce its labour costs by
$200,000 a year for 4 years, and the technology may be depreciated for tax purposes by
the straight-line method to zero over the 4 years. The company thinks that it can sell the
technology at the end of 4 years for $30,000.
The technology will need to be stored in a building, currently being rented out for
$40,000 a year under a lease agreement with 4 yearly rental payments to run, the next
one being due at the end of one year. Under the lease agreement, Perth Projects Ltd
can cancel the lease by paying the tenant (now) compensation equal to one year’s rental
payment plus 10%, but this amount is not deductible for income tax purposes.
This is not the first time that the company has considered this purchase. Twelve months
ago, the company engaged Marvel Consultants, at a fee of $30,000 paid in advance, to
conduct a feasibility study on savings strategies and Marvel made the above
recommendations. At the time, Perth P:rojects did not proceed with the recommended
strategy, but is now reconsidering the proposal.
Perth Projects further estimates that it will have to spend $20,000 in 2 years’ time
overhauling the technology. It will also require additions to current assets of $30,000 at
the beginning of the project, which will be fully recoverable at the end of the fourth year.
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Perth Projects Ltd’s cost of capital is 10%. The tax rate is 30%. Tax is paid in the year in
which earnings are received.
REQUIRED:
(a) Calculate the net present value (NPV), that is, the net benefit or net loss in
present value terms of the proposed purchase costs and the resultant
incremental cash flows.
[HINT: As shown in the text-book, it is recommended that for each year you
calculate the tax effect first, then identify the cash flows, then calculate the
overall net present value.]
Answer:
Depreciation = (cost of technology – salvage value) / 4
= ($600,000 - $30,000) / 4
= $570,000/4
= $142,500
Table of cash flows for Perth Projects’ purchase of technology:
Year Year 1 Year 2 Year 3 Year 4
Saving (income) $2,00,000 $2,00,000 $2,00,000 $2,00,000
Less: Depreciation $1,42,500 $1,42,500 $1,42,500 $1,42,500
Less: Interest on loan $60,000 $60,000 $60,000 $60,000
Less: Overhauling
expenses $10,000 $10,000
Less: Loss of rent $40,000 $40,000 $40,000 $40,000
Taxable income -$42,500 -$52,500 -$42,500 -$52,500
Income taxes (30%) -$12,750 -$15,750 -$12,750 -$15,750
Income after tax -$29,750 -$36,750 -$29,750 -$36,750
Add: Depreciation $1,42,500 $1,42,500 $1,42,500 $1,42,500
Cash from operations $1,12,750 $1,05,750 $1,12,750 $1,05,750
Less: Principal
repayment $6,00,000
Add: Terminal value $51,000
Net cash flow $1,12,750 $1,05,750 $1,12,750 -$4,43,250
Initial outflow = $600,000 + $30,000 + $44,000 - $600,000
= $74,000
After tax salvage of technology = $30,000 – $9,000 = $21,000
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Recovery of working capital = $30,000
Terminal value = $30,000+$21,000 = $51,000
Net Present Value = (74,000) + 11,2750 / (1.1)1 + 105,750 / (1.1)2 + 112,750 / (1.1)3 +
(443,250) / 1.14
NPV = ($102,138.3)
It is assumed the working capital is recovered at the end of the project.
(b) Should the company purchase the technology? State clearly why or why not.
Answer:
No, the company should not purchase the technology as the NPV of the project is
negative which means the cash outflows are more than the cash inflows. The investment
is not profitable and hence should not be accepted.
END OF ASSIGNMENT QUESTIONS
ADDITIONAL PAGE 1 (for workings, or if your answers take more space.)
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ADDITIONAL PAGE 2 (for workings, or if your answers take more space).
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ADDITIONAL PAGE 3 (for workings, or if your answers take more space).
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