Goldstar Manufacturing Limited is evaluating an investment opportunity that would

Goldstar Manufacturing Limited is evaluating an investment opportunity that would

Subject: Business    / Finance
Question

QUESTION FOUR

(a) Goldstar Manufacturing Limited is evaluating an investment opportunity that would require an outlay of sh.100 million. The annual net cash inflows are estimated to vary according to economic conditions.

Economic conditions

Probability

Cash flow

Sh. million

Very good

Good

Fair

Poor

.10

.45

.30

.15

35

28

24

18

The firm’s required rate of return is 14 percent. The project has an expected life of six years.

Required:

Compute the expected net present value (NPV) of the proposed investment. (5 marks)

(b) Pwani Limited is planning advertising campaigns in three different market areas. The estimates of probability of success and associated additional profits in each of the three markets are provided below:

Market 1

Market 2

Market 3

Profit

Sh.

Profitability

Sh.

Profit

Sh.

Profitability

Sh.

Profit

Sh.

Profitability

Sh.

Fair

Normal

Excellent

10,000

18,000

25,000

.40

.50

.10

5,000

8,000

12,000

.20

.60

.20

16,000

20,000

25,000

.50

.30

.20

Required:

(i) Compute the expected value and standard deviation of profits resulting from advertising campaigns in each of the market areas. (5 marks)

(ii) Rank the three markets according to riskiness using the coefficient of variation.

(2 marks)

(c) Rugongo Ltd. is an ungeared company operating in the processed food industry. The company is planning to take over Sauce Ltd. but is unsure on how to value its net assets. Rugongo Ltd.’s analysts have assembled the following information:

1. Sauce Ltd.’s balance sheet as at 30 September 2003

Sh.’000’

Sh.’000’

Fixed assets

Current assets:

Stock

Debtors

Cash

Current liabilities:

Creditors

Bank overdraft

Net current assets

Financed by:

Issued share capital (Sh.10 par value)

Profit and loss account

Shareholders funds

40,000

80,000

–

100,000

30,000

140,000

(10,000)

130,000

100,000

30,000

130,000

In its most recent trading period ended 30 September 2003, Sauce Ltd.’s sales were Sh.500,000,000, but after operating costs and other expenses including a depreciation charge of Sh.20,000,000, its profit after tax was Sh.20,000,000. This figure includes an extraordinary item (sale of property) of Sh.5,000,000. The full years dividend was Sh.5,000,000.

Sauce Ltd. has recently followed a policy of increasing dividends by 12% per annum. Its shareholders require a return of 17%.

The price earnings ratio of Rugongo Ltd. is 14 times and that of Sauce Ltd. is 8 times.

More efficient utilization of Sauce Ltd.’s assets could generate operating savings of Sh.5,000,000 per annum after tax.

Required:

(i) Current market value of Sauce Ltd.’s share. (2 marks)

(ii) Explain why the market value might differ from the book value. ( 2 marks)

(iii) A company experiencing ordinary growth, has high liquidity and much unused borrowing capacity. (2 marks)

(iv) The value of Sauce Ltd. using the discounted cash flow method. (2 marks)

(Total: 20 marks)