Question 1

KFC Ltd is evaluating a new machine costing $400,000. It is expected to last for 10 years with a negligible salvage value. The following information is given to determine the net cash flows for the machine. Installation costs $10,000. It is a specialized machine requiring specially trained workers to operate it.

The training cost is expected to amount to $10,000. Company's policy for depreciating the plant and equipment is the straight line method over the 10 years. The machine would need an increase in working capital of $40,000. KFC Ltd has to borrow $200,000 at 8% interest per year.

The company estimates that there will be an increase in earnings before interest and tax of $100,000 per year in using this machine. KFC Ltd requires a 10% return on its investments. The company's tax rate is 34%.

Required:

Calculate the following:

i) What is the initial outlay for this project?

ii) What are the annual after- tax cash flows for years 1-9?

iii) What is terminal cash flow in year 10?

iv) Advice whether the machine be purchased.

Question 2

Modigliani and Miller (MM) argue that 'The dividend decision is an irrelevant one'.

Explain, giving reasons, why you agree or disagree with MM's theory. (12 Marks)