Evaluate the financial acceptability of an investment with the following characteristics.

The investment has five years life span from the year preceding the latest year of your company’s financial statements. For example, if the latest financial accounts are published as of 2022, the preceding year (2021) should be treated as Year 0.

Free cash flow (FCF) should be estimated from the company’s profit before tax (operating profit) after adjustment for non-cash items and using the UK inflation rate assuming it’s constant over the next 5 years. FCF are assumed to be in current terms as at the latest date of published financial accounts. FCF is constant except for changes due to inflation.

UK tax rate is assumed to be constant over the life span of the project.

It is anticipated that working capital of 15% of the net free cash flow (FCF after tax) will be needed at the beginning of each year and released at the end of the project.

Project cost has been estimated to be 25% of the entire estimated free cash flows (FCF before tax) of the investment.

A balancing allowance of 2% of the cost of the project is available at the end of year 5 of the project. Scrap value is estimated to be 7% of the project’s cost.

Royalty payment of 1.5% of net free cash flow (FCF after tax) in the second and third year of the project is expected to be received from a foreign subsidiary using the same currency with your assigned company in the third and fourth year of the project’s life span. The tax rate of the foreign subsidiary is 30% lower than that of the UK. The royalty is allowed for tax in the accounts of the foreign subsidiary.

The project is expected to be financed entirely by the company’s equity. You are expected to use an appropriate cost of capital in your evaluation.

Required:

Using Capital Asset Pricing Model (CAPM), compute the company’s cost of equity of your company and evaluate it accordingly.

Answer rating: 100% (QA)

Calculations for evaluating the financial acceptability of the investment 1 Estimated pretax FCFs Ye... View the full answer