QUESTION $2$

$[20$ MARKS$]$

Buildings Ltd$.$ is considering a new project in a different industry than the one it currently operates in$.$ The company is currently active in the construction industry and wants to diversify into the real estate development industry. The management wishes to do so due to the volatiity of the construction industry and has some concerns regarding the current valuation of this new project given its risk profile. Some of the most pertinent information has already been gathered by the team working on the feasibility study of the project and it is summarised as below:

Initial cost of the project $($Year $0)$: R$8$ million

Expected cash flows are as follows:

$\backslash$table$[[$Year$,1,2,3],[$Sales $($Rands$),6$ million,$6$ million,$9$ million$]]$

You have also gathered the following information from the company accounts and some external sources:

Inflation: $2\%$

Current WACC $/$ Cost of equity. $13\%$

Risk$-$free rate: $6\%$

Market risk premium: $5\%$

Tax rate: $27\%$

The write$-$off period for the project is $3$ years using the straight$-$line method

Variable costs are equal to $50\%$ of the expected cash inflows

The initial RB million cost is related to various assets and the entire amount is depreciable over the write$-$off period. No scrapping proceeds are expected at the end of the project and no fixed costs are expected, only variable costs. The company is currently wholly financed by equity which is expected to remain the case for the foreseeable future. The company currently has a beta of $1\mathrm{.}8$ while the beta of the real estate development industry is $1\mathrm{.}1.$

Required:

You further agreed to perform the following tasks:

a$.)$ The cash flows are presented in real terms, and you must determine their nominal values by inflating them utilising the inflation rate.

b$.)$ Identify the relevant cash flows and tax effects of the project.

$(6)$