Question

You work as assistant to the Chief Financial Officer (“CFO”) of Delicious
Candies (the “Company”), which produces a range of sweets in the
United Kingdom (“UK”) and exports them to continental Europe (please
disregard any impact of the foreseen exit of the UK from the European
Union (“EU”)).
The CFO asked you to evaluate the investment in a new production
equipment (the “Project”) recently discussed by Company’s top
management and prepare a report. The purpose of such investment
would be to increase production capabilities in light of strong
indications from the market of growing demand in multiple countries
that the Company serves.
The investment cost of such equipment, including set-up, is GBP
2,800,000 (all payable up-front); the Company expects to use it for five
years and then to re-sell it to a smaller producer at 25% of the original
value. Maintenance costs are estimated at 4% of the investment cost
in year 1 (i.e. 12 months after the purchase of the equipment) and
then to grow annually by further 2% from year 2 to year 5. The
increase in net cash profit is estimated at GBP 600,000 in year 1, then
growing annually by 20% from year 2 to year 5 (that reflects the need
to enhance year after year Company’s distribution capabilities in certain
countries of continental Europe).
Required:
You are asked to include the following in your report to the CFO:
i) Cash flow, with timeline, reflecting all cash inflows and outflows
of the Project;
ii) Assuming that Company’s required rate of return is 8%,
calculation of the project’s NPV and assessment of whether the
Project should be undertaken or not;
iii) Analysis of the assumptions made for the Project (provided
above), highlighting what risk each of them entails (in other
words: what could go wrong), ideally with a sensitivity analysis.
[25 Marks]
iv) Recommendation to the CFO in case another investment
opportunity is considered by the Company and has an NPV
similar to the Project (value of NPV: undisclosed), under the

assumption that Company’s financial resources for any
investment are limited;
v) Change (if any) in the answers to i), ii) and iii) above, should
Company’s required rate of return become 12% in light of
higher returns demanded by Company’s top management.
[10 Marks]

Note:
Calculations are required for i), ii), iii) and v). Calculations are not
required for iv), however an example may be included to help support
the answer.

Question 2
You are an investment banker advising Blue Sky (the “Company”),
which manufactures and sells solar panels. The Company has common
stock outstanding i) with market price currently at EUR 20 per share
and ii) for which the last dividend paid was EUR 0.5 per share with
analysts foreseeing an increase by 35% per year going forward. The
expected risk-free interest rate is 2%, whereas the expected market
premium is 5%. The beta of Company’s common stock is 1.2.
Required:
The Company asked you to assess the following:
i) Cost of equity using the dividend valuation model vs the capital
asset pricing model;
The Company is evaluating its cost of capital under alternative
financing solutions. It expects to be able to issue new debt at par with
a coupon rate of 8% and to issue new preferred stock at EUR 22 a
share, with an EUR 1.5 dividend per share. Company’s marginal tax
rate is 35%. The Company needs your advice to address the following:
ii) On the basis of the data above: cost of debt; cost of common
stock; cost of preferred stock;
iii) If Company raises new capital using 55% debt, 30% common
stock, 15% preferred stock: what is its WACC?
iv) And what if it raises new capital using 35% debt, 50% preferred
stock, and 15% preferred stock? Comment the difference in
WACC under iii) and iv).

[35 Marks]

Question 3
Tesla (the “Company”) is a U.S.A.-based global automotive and energy
company. It specialises in manufacturing electric cars.
His iconic founder, Elon Musk, has relentlessly pushed for the Company
to achieve sustainable net profits by ramping up production of its car
models, albeit with a number of setbacks. The evolution of its market
capitalisation since inception testifies the belief of investors in its
chances to succeed (rapid growth in 2013 – 2015 and again in 2017),
together with considerable uncertainty over the sustainability of its
business model (lateral movement in 2016 as well as in 2018).
Given Musk’s at times erratic behaviour and questions about
Company’s financial health as well as ability to build cars at larger scale,
Tesla may be at an inflection point.
Required:
Critically evaluate the competitive position of Tesla against the
traditional car manufacturers (please pick: one between General
Motors and Ford; ii) one between Volkswagen and Renault). Is Tesla
going to stay independent or will it ultimately have to merge with / be
acquired by a larger group? Justify your view.
If you believe that it will stay independent, what is your assessment of
its current capital structure and how sustainable is it in the long term
(for example: need for capital injection to fund investments)?
Instead, if you believe that Tesla will have to merge with / be acquired
by a larger group, how such a transaction could be financed (assume
that Tesla is effectively acquired by a larger company which will get
control over it) and what benefits could derive to Tesla under that
scenario (for example: lower WACC?).

[30 Marks]

Answer 1

Answer 1:

Please find below following assumption table :

		Comments	Type of Cash Flow
Capital Investment	2800000		Cash Outflow
Maintainence Cost	4% of Capital Invetment		Cash Outflow
Maintainence Cost escalation	2%	From year 2 to 5
Increase in Net profit in year 1	600000		Cash Inflow
Escalation in net profit	20%	From year 2 to 5
Salvage Value	25% of original investment

  (i). Cash flow, with timeline, reflecting all cash inflows and outflows of the Project are given in following table:

Year Counter	0	1	2	3	4	5
Capital Investment	2800000
Maintainence Cost	112000	114240	116524.8	118855.3	121232.4	123657.05
Cash Outflow	2912000	114240	116524.8	118855.3	121232.4	123657.05
Increase in net profit	600000	720000	864000	1036800	1244160	1492992
Salvage Value						700000
Cash Inflow	600000	720000	864000	1036800	1244160	2192992
Net Cash Flows(Cash Inflow-Cash outflow)	-2312000	605760	747475.2	917944.7	1122927.6	2069335

(ii). Assuming that Company’s required rate of return is 8%, calculation of the project’s NPV and assessment of whether the
Project should be undertaken or not;

Taking Net Cash flows for years calculated above and using excel formula for NPV:

Net Cash Flows(Cash Inflow-Cash outflow)	-2312000	605760	747475.2	917944.7	1122927.6	2069335
NPV	1714965.185

NPV(8%,Net cash Flows)

(iii). Analysis of the assumptions made for the Project (provided above), highlighting what risk each of them entails (in other
words: what could go wrong), ideally with a sensitivity analysis.

Here is the tentative value of NPV , when we change escalation of maintenance cost and maintenance cost as % of capital investment:

		Escalation	Escalation	Escalation	Escalation
NPV	1714965.185	2%	3%	4%	5%
Maintenance Cost as % of capital investment	4%	1714965.2	1702408.6	1689532	1676328.5
Maintenance Cost as % of capital investment	5%	1579479.4	1563783.6	1547687.9	1531183.6
Maintenance Cost as % of capital investment	6%	1443993.6	1425158.7	1405843.8	1386038.7
Maintenance Cost as % of capital investment	7%	1308507.9	1286533.8	1263999.8	1240893.7

Here is the tentative value of NPV , when we change escalation of net profit and increase in net profit in year 1:

		Escalation	Escalation	Escalation	Escalation
NPV	1714965.185	10%	15%	20%	25%
Increase in Net profit in year 1	400000	798101.1	1229045.7	1714965.2	2261546.7
Increase in Net profit in year 1	500000	798101.1	1229045.7	1714965.2	2261546.7
Increase in Net profit in year 1	600000	798101.1	1229045.7	1714965.2	2261546.7
Increase in Net profit in year 1	700000	798101.1	1229045.7	1714965.2	2261546.7

Answer (iv):

Under similar project with almost same NPV , company CEO should choose the investment which aligns with the business of the company so that it can benefit the company in long term , so the investment chosen should be an strategic investment

Answer (v)

NPV in case we increase IRR to 12% is given as follows in table:

Net Cash Flows(Cash Inflow-Cash outflow)	-2312000	605760	747475.2	917944.7	1122927.6	2069335
NPV	1219599.748

Company should still proceed with the project as NPV is positive.

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