BBMF2814 FINANCIAL MANAGEMENT 2 RAC

Week 11 Tutorial Questions

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Question 1

CG Pharmaceutical Bhd. (CG) is evaluating an investment proposal to manufacture a new drug Z10.
This drug has performed well in test marketing trials conducted recently by the company’s research
and development division.

The following information relating to this investment proposal has now been prepared:

Investment cost : RM4 million

Scrap value : RM200,000
Selling price (current price terms) of Z10 : RM30 per unit
Expected selling price inflation : 2% per year
Variable operating costs (current price terms) : RM10 per unit
Fixed operating costs (current price terms) : RM200,000 per year
Expected operating cost inflation : 5% per year

Forecast demand (units) for Z10 for the next four years are as follows:

Year 1 2 3 4
Demand (units) 70,000 80,000 100,000 60,000

CG uses a nominal discount rate of 10% per year and a target return on capital employed of 28% per
year. Ignore taxation.

Required:

(a) Calculate the following values for the investment proposal:

(i) Net present value (to the nearest RM’000).

(ii) Internal rate of return.

(iii) Return on capital employed (accounting rate of return) based on average investment.

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BBMF2814 FINANCIAL MANAGEMENT 2 RAC
Week 11 Tutorial Questions
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Question 2

Duo Co needs to increase production capacity to meet increasing demand for an existing product,
‘Quago’, which is used in food processing. A new machine, with a useful life of four years and a
maximum output of 600,000 kg of Quago per year, could be bought for $800,000, payable
immediately. The scrap value of the machine after four years would be $30,000. Forecast demand and
production of Quago over the next four years is as follows:

Year 1 2 3 4
Demand (kg) 1.4 million 1.5 million 1.6 million 1.7 million

Existing production capacity for Quago is limited to one million kilograms per year and the new
machine would only be used for demand additional to this.

The current selling price of Quago is $8.00 per kilogram and the variable cost of materials is $5.00
per kilogram. Other variable costs of production are $1.90 per kilogram. Fixed costs of production
associated with the new machine would be $240,000 in the first year of production, increasing by
$20,000 per year in each subsequent year of operation.

Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances (tax-
allowable depreciation) on a 25% reducing balance basis. A balancing allowance is claimed in the
final year of operation.

Duo Co uses its after-tax weighted average cost of capital when appraising investment projects. It has
a cost of equity of 11% and a before-tax cost of debt of 8.6%. The long-term finance of the company,
on a market-value basis, consists of 80% equity and 20% debt.

Required:

(a) Calculate the net present value of buying the new machine and advise on the acceptability of the
proposed purchase (work to the nearest $1,000).

(b) Calculate the internal rate of return of buying the new machine and advise on the acceptability of
the proposed purchase (work to the nearest $1,000).

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BBMF2814 FINANCIAL MANAGEMENT 2 RAC
Week 11 Tutorial Questions
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Question 3

Brilliant Bhd. (“Brilliant”) is a listed company that manufactures, markets and distributes a large
range of electronic components mainly for the export markets. All its manufacturing plants are located
in Malaysia. It has grown successfully from its small beginning about 20 years ago. However, it has
not seen any substantial growth in recent years. The Board of Directors is concerned that Brilliant
may be heading towards a decline state in the near future and has instructed the management team to
devise a strategic plan.

The Business Development Director has proposed to acquire a licence from a new technology
company (“Licensor”) that has recently patented a new-age electronic component that is far superior
to conventional ones in terms of performance, environmentally sustainable manufacturing process and
bio-degradable (for disposal). Brilliant could commercialise this technology in a wide range of
applications for existing and new customers.

A licence fee of RM20 million is required upon signing the licence agreement. Annual royalty
payment of 10% on sales revenue is payable annually at the end of each financial year. A preliminary
non-refundable assessment fee of RM1 million is payable to enable Brilliant to conduct a feasibility
study on commercialisation of the product. Consultants to be engaged by Brilliant to assist in this
feasibility study are estimated to cost RM2 million, payable upon completion of the feasibility study.
Brilliant shall be given one year to conduct the feasibility study, after which, if Brilliant is still
interested, the licence agreement will be signed.

The Licensor has estimated that a set-up period of one year (after signing of licence agreement) is
required before the new plant is operational for commercial production. During the set-up period, the
Licensor will have to be appointed as project manager at a fee of RM2 million (payable upon signing
the licence agreement) to ensure the successful implementation and commercial production.

Projected cash flows (in real terms) are as follows:

Year
Assume that all cash flows
0 1 2 to 11
occur at the end of each year
RM million RM million RM million
Equipment cost
20 20
(negligible disposal value)
Contractor’s fees 10
One-time hire of special machinery 5
Test-run and training 5
Investment in working capital
(release of this same amount of working capital at 2
the end of Year 11 is assumed to be in real terms)
Commercial production from years 2 to 11:
Sales revenue 80
Variable costs 40
Additional fixed costs per annum 4
Allocated head office overheads per annum 1

Brilliant evaluates investments over a planning horizon of 10 years. Therefore, the above project will
be assumed to terminate at the end of Year 11 and the equipment will be disposed. Brilliant’s gearing
ratio [Debt:(Debt + Equity)] is currently 20% and it is estimated that, with this new investment, its
capital structure and risk profile will remain unchanged.

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BBMF2814 FINANCIAL MANAGEMENT 2 RAC
Week 11 Tutorial Questions
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Additional information:

 Corporate tax rate in Malaysia is 25%, payable at the end of the same year when profits are
earned (assume that tax payments are in real terms).
 Capital allowance of 10% on a straight-line balance basis is claimable (on the full cost of
equipment only) and tax savings, will be enjoyed starting from the end of year 2 until year 11
(assume that tax savings are in real terms).
 The real risk-free rate of return from government securities is 3.55% per annum.
 The market risk premium is expected to be 7%.
 Brilliant’s beta is 1.1.
 Brilliant’s real post-tax cost of debt is 5% per annum.

Required:

(a) Calculate the net present value of the proposed investment, including a calculation of Brilliant’s
weighted average cost of capital (WACC). Show all relevant workings. (20 marks)
(b) Explain the results in (a) above. (1 mark)
(c) Give your recommendation to the Board of Directors of Brilliant and explain your justifications in
support of your recommendation. (4 marks)
[Total: 25 marks]

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