Project A has the potential to be expanded into the export markets starting from the end of
Question:
Project A has the potential to be expanded into the export markets starting from the end of Year 3. Preliminary appraisal estimated that the investment cost of RM20 million will generate a net present value of RM4 million (as at the end of Year 3). Cost of capital is 12% and the volatility of cash flows is 35%. The Business Development Director has proposed two additional investment projects that are focused on improving the existing business operations in order to increase Lavender's market share and profitability. However, the Chief Financial Officer (CFO) is facing capital constraints this year due to the overall gearing ratio target of 60% being imposed by the board. Therefore, only RM50 million in total financing will be raised in Year 0. It is anticipated that there will no longer be any capital constraints from Year 1 onwards. The following are details of the two additional investment projects, which are not divisible: Project B - This is an investment into product development to upgrade the existing product in order to compete more effectively against the substitute products introduced by the competitors. Initial investment cost of RM15 million is required in Year 0 and it will generate a positive net present value of RM2 million over its 4 years of useful life. Project C - This is an investment to automate the existing business operations in order to improve the productivity and reduce overhead costs so as to improve the profit margin. Initial investment cost of RM20 million is required in Year 0 and it will generate a positive net present value of RM8 million over its 4 years of useful life. The value of the option to expand Project A into the export markets should be added to Project A's existing net present value when comparing against Project B and Project C in order to make the capital rationing decision. Project A is also not divisible.
Required: The CFO has requested you, the Financial Analyst, to write a report to:
(a) Calculate the net present value (NPV) of Project A.
(b)Based on the figures in (a) above, calculate the following in respect of Project A:
• Modified Internal Rate of Return (MIRR)
• Macaulay duration
• Value at risk (VAR) at 95% confidence level.
(c) Interpret the results of all the calculations in (a) and (b) above.
(d) Calculate the value of the option to expand Project A into the export markets. Comment on the result. Reference: Advanced Financial Management (ACCA) Topic on: Investment appraisal and real option
Financial Reporting Financial Statement Analysis and Valuation a strategic perspective
ISBN: 978-1337614689
9th edition
Authors: James M. Wahlen, Stephen P. Baginski, Mark Bradshaw