ASSIGNMENT 1

ATTEMPT ALL QUESTIONS

Question 1

Ori plc is evaluating two projects. The first involves $ 4.725m expenditure on new machinery to expand the company's existing operations in the textile industry. The second is the diversification into the packing industry and will cost $ 9.275m

Ori's summarized balance sheet and those of Canall plc and Sealalot plc companies in the packaging industry are shown below.

Ori plc ($m)

Canall plc ($m)

Sealalot plc($m)

Fixed Assets

96

42

76

Current Assets

70

82

65

Less Current Liabilities

(70)

(72)

(48)

121

52

93

Financed by:

Ordinary shares

15

10

30

Reserves

50

27

50

Medium and Long term loans

56

15

13

121

52

93

Ordinary share price (pence)380

180

230

Debenture($) 104

112

-

Equity beta 1.2

1.3

1.2

1.Ori and Sealalot 50 pence par value, Cannal 25 pence par value

2.Ori 12% debentures 1998-2000, Canall 14% debentures 2003, Sealalot medium term bank loan

Ori proposes to finance the expansion of textile operations with a $ 4.725 m 11% loan stock issue, and the packaging investment with a $ 9.275 m rights issue at a discount of 10% on the current market price. Issue cost may be ignored.

Ori's managers are proposing to use a discount rate of 15% per year to evaluate each of these projects.

The risk free rate of interest is estimated to be 6% per year and the market return 14% per year. Corporate tax is at the rate of 33% per year.

Required.

a.Determine whether 15% per year is an appropriate discount rate to use for each of these projects.Explain your answer and state clearly any assumptions that you make

b.Ori's marketing director suggests that it is incorrect to use the same discount rate each year for the investment in packaging as the early stages are riskier and should be discounted at a higher rate. Another board member disagrees saying that more distant cash flows are riskier and should be discounted at a higher rate. Discuss the validity of the views of each of the directors