Drogba plc is operating in a highly competitive gaming industry. The industry is technologically and innovatively driven and has not been impacted negatively by Covid 19. The company recently had a portion of its market share reduced due to two of its main competitors having merged and this has resulted in their existing customers switching to the competition due to better pricing. The market is very volatile and Drogba’s share price has only grown by 0.03% over the past twelve months despite continued investment Drogba plc is considering the addition of a new product to its existing range. Drogba plc has had some difficulty in forecasting the performance of this product. As a result, it hired a firm of market consultants to assist with planning and modelling. The cost of this assignment was agreed at €275,000, payable to the consultants three months after delivery of their final report. The main details of the market consultant’s report, which has just been presented to the Board of Drogba plc, are as follows: The product is expected to last for four years when production will then cease. Sales in the first year are estimated at 4,200 units. The number of units sold is expected to grow at an annual rate of 10% The initial selling price of the product will be set at €100 per unit. It is expected that the selling price can be increased by 5% from the third year. Machinery costing €400,000 will be required immediately with an expected residual value of €70,000 when the project ends. Drogba plc has a policy of depreciating the cost of machinery in its financial accounts over four years on a straight-line basis. Drogba plc plans to finance the machinery with a bank loan at an annual fixed interest rate of 8%. Working capital of €30,000 will be required from the start of the project. Labour, direct materials and variable overheads are estimated at €20, €25 and €5 respectively per unit in the first year. No change in these costs are expected, except that an agreement has been reached with the trade union whereby labour costs will be increased by 5% from year three onwards. Fixed overheads of €60,000 per annum have been estimated. Forty per cent of this figure relates to existing fixed costs of the organisation, which have been allocated to the project. The remainder relates directly to the new product. Production will be carried out in a vacant building which is owned by Drogba plc. If not used to produce the new product the building could be rented out for €50,000 per annum over the next four years. Corporation Tax is at the rate of 20% and tax liabilities are settled in the year in which they arise. The machinery cost will qualify for capital allowances on a straight-line basis over four years. Drogba plc’s after-tax cost of capital is 9% Drogba’s shareholders have received a consistent dividend over the past two years. The directors of Drogba plc are considering the possible purchase of Athalon Ltd, a private company which makes innovative visual chips for gaming consoles, a business which is not currently included among Spin plc’s activities. Recently it has had trading difficulties. Investment in facilities In addition to the proposed acquisition Drogba plc’s board is looking to finance additional investments in facilities over the next three years, forecast to cost up to €27m. The board members have made a number of suggestions about how this can be done: Director A (Andrew) has suggested that the company does not have a problem with funding new investments, as it has cash available in the reserves of €17m. If extra cash is required soon, Drogba plc could reduce its investment in working capital. Director B (Brian) has suggested convertible loan bonds as a means of financing the investment. Director C (Colin) has commented that although a high dividend has just been paid, dividends could be reduced over the next three years, allowing spare cash for investment. Colin is concerned of the impact on the share price if they announce a withholding of dividends over the next three years. Required:

a) Evaluate if the directors current strategy is working. As part of the evaluation analyse the acceptability of the above project using capital budgeting techniques net present value and payback of the proposal and prepare a report for Drogba plc’s directors, outlining your recommendation. Your report should include if this project will impact the growth in the firms share price and qualitive factors, other than the figures above, which you feel are important.

(b) In a scenario where due to its current taxation position Drogba plc may not be in a position to use the capital allowances on the new machinery. Critically assess the impact which this would have on the project and advise as to whether the project is still worthwhile without the benefit of the capital allowances.

(c) Critically assess the opinions of each director on financing the proposed 27m investments In your analysis you should include a consideration of real-world effects such as taxes, transaction costs.

( d) In relation to the Drogba’s assessment of a suitable valuation value of Athalon, critique the rationale underlying the assets and the earnings bases of valuation.

(e) ‘Capital Structure can have no influence on the value of a firm.’ Miller and Modigliani (1958).

 

Answer rating: 100% (QA)

a The directors current strategy is not working The company is not generating enough revenue to cove... View the full answer