QUESTION 7 INVESTMENT IN A NEW PRODUCT

Initial Investment = 400,000

Cash flow per unit
Sales = 21
Variable costs = 16
et Cash flow per unit = !
a. NPV at 24%
"nnual cash flow = ! # 22,000 = 110,000
$resent Value of "nnual cash flow 110,000 # annuit% factor for 10 %ears
at 24&
110,000 # '(6)1* = 40!,00*
+ess Initial Investment 400,000
et $resent Value ,24&- !,00*
$resent Value of "nnuit% cash flow 110,000 annuit% factor for 2!&
110,000 . '(!/0! = '*2,/!!
+ess Initial Investment 400,000
$V ,2!&- ,/,24!-
1
Calculate the Internal 0ate of 0eturn
1ormula2 I00 = "& 3 $V
"
,4 5 "-
$V
"
5 $V
4
I00 = 24& 3 !,00* ,2!624-&
!,00*3/,24!
= 24& 3 !,00* ,2! 5 24-&
12,2!4
= 24& 3 ,0(40)/ . 1-&
= 24& 3 0(40*
I00 = 24(4&
i. If sales vol!e is "e#$e# %& '% $as( flo) *e" +it
Sale 21
Cost 16
Cash flow per unit !
Volume sol7 *!& of 22,000
"nnual cash flow = 20,*00 . !
= 104,!00
"nnuit% factor ,22&- '(*2'2
40*,*/4
+ess Initial Investment 400,000
$V *,*/4
2
$resent Value of "nnuit% cash flow 104,!00 annuit% factor for 2'&
104,!00 . '(/**' = '*/,02/
+ess Initial Investment 400,000
$V ,2'&- ,2,*/'-
I00 = 22& 3 *,*/4 ,2'622-&
*,*/432,*/'
= 22& 3 *,*/4 ,2' 5 22-&
12,*4/
= 22& 3 ,0(//0 . 1-
= 22& 3 0(//&
I00 = 22()&
ii. If sales *"i$e "e#$e %& '%
Cash flow per unit
Sale ,*!& 3 21&- 1*(*!
+ess variable cost 16
'(*!
"nnual cash flow = '(*! # 22,000
= )6,*00
"nnuit% factor of 1/& for 10 %ears # 4(6!)6
404,)'2
+ess Initial Investment 400,000
$V 4,)'2
"nnual cash flow = '(*! # 22,000
= )6,*00
3
"nnuit% factor of 1)& for 10 %ears # 4(4*41
'*0,!'/
+ess Initial Investment 400,000
$V ,*,46'-
I00 = 1/& 3 4,)'2 ,1) 5 1/-&
4,)'23*,46'
= 1/& 3 4,)'2 ,1) 5 1/-&
14,2*!
= 1/& 3 ,0('') # 1-&
I00 = 1/('&
iii. If va"ia%le #i"e$t $osts i+$"eases %& '%
Cash flow per unit
Sale 21
+ess cost 16 #1(0! 16()
Cash flow per unit 4(2
"nnual cash flow = 4(2 # 22,000
= *2,400
"nnuit% factor ,1)&- 4(4*41
41!,2!!
+ess Initial Investment 400,000
$V 1!,2!!
4
$resent Value of "nnuit% cash flow *2,400 annuit% factor for 20&
*2,400 # 4(1*2! = ')/,')/
+ess Initial Investment 400,000
$V ,20&- ,12,61'-
I00 = 1)& 3 1!,2!! ,20 5 1)-&
1!,2!! 3 12,61'
= 1)& 3 1!,2!! ,20 5 1)-&
2/,)6)
= 1)& 3 ,0(!4/ # 2-&

= 1)& 3 1(0*4
I00 = 1*(1&
$, E-*lai+ to t(e !a+a.e!e+t tea! (o) t(is a+al&sis $a+ (el* to #i"e$t
atte+tio+ a+# f"t(e" )o"/ to i!*"ove t(e li/eli(oo# of a s$$essfl
*"o0e$t i!*le!e+tatio+.
"s in7icate7 the internal rate of return is the 7iscount rate that e8uates the
present value of the e#pecte7 future cash inflows an7 outflows( It measures the
rate of return of the pro9ect an7 assures that all cash flows can be reinveste7 at
the I00( :herefore if the I00 is less than the cost of capital ,the 7ecision
criterion- the pro9ect shoul7 not be pursue7( :he net present value calculations
;ive a static future out6turn of an investment pro9ect( In man% real business
situations it is 7esirable to ;enerate a complete an7 realistic impression of what
ma% happen to $V an7 I00 in con7itions of uncertaint%( et present value
calculations rel% on the appraiser ma<in; assumptions about some critical
variables2 e(;( sale price of the pro7uct, the cost of labour an7 the amount of
initial investment are all set in sin;le values for input into the formula( It mi;ht be
enli;htenin; to e#amine the 7e;ree to which the viabilit% of the pro9ect chan;es,
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as measure7 b% the I00, as the assume7 values of these <e% variables are
altere7( It will be useful to <now how sensitive the I00 is to chan;es in the
components values(
Se+sitivit& a+al&sis is essentiall% a =what5if> anal%sis( 1or e#ample in the case
of the compan% un7er review a !& increase in the variable costs ma<es the
pro9ect still viable if the cost of capital is less than the I00 of 1*(1&( It will also be
reali?e7 that a shortfall of !& in sellin; price an7 volume of sales respectivel%
;ive 7ifferent I00s ,i(e( 1/('& an7 22()&-( otice that the I00 before the three
variables were altere7 was 24(4&( :hese are pointers to areas of the pro9ect that
are more critical an7 these will 7eserve more attention( In this particular case
therefore the most sensitive of the three variables is sales price(
6
QUESTION 1 R2W Pl$
:otal assets = @!0m
Value of shares = @*0m
$urchase of 2! li;nite mines = @*00m
1inancin; of purchase = @!00m new e8uit% capital
@400m fi#e7 interest 7ebt

a. NPV of R2W *"o0e$tio+s
:ime 0 1 2 ' 4 !
Sales
+ess costs
et cash flow ,*00- 1'0 14! 1!0 1'0 1!0
Aisc(1actor 1 0()//2 0(/6*! 0(6/!0
0(!*21 0(!1*4
Aisc( cash flow ,*00- 114(04 111(!) 101(2! /6(*/ //(*1
$V for Bears 0 to 4 = 6*00 3 114(04 3 111(!) 3 101(2! 3 /6(*/ = 64*6(16
$erpetuit% from %ear !
= 1!0 = @1,0/1(4'
0(14
$erpetuit% from %ear 0 = 10/1(4' . 0(!*21
=@6'4('*
:herefore, $V =@6'4('* 6 @4*6(16 = @1')(2'
7
A !o"e o*ti!ist fo"e$ast

:ime 0 1 2 ' 4 !
et cash flows 6*00 260 2/6(/ 2)'('' 2/1 2)0
Aiscount factor 1 0()//2 0(/6*! 0(6/!1 0(!*21 0(!1*4
Aisc(cash flows ,*00- 22)(0/ 212(*2 1*1(2) 160(46


$V for Bears 0 to 4 = 6*00 3 22)(0/ 3 212(*2 3 1*1(2) 3 160646 = 610/(2/
$erpetuit% from %ear !
= 2)0 = @2,000
0(14
$erpetuit% from %ear 0 = 2,000 . 0(!*21
=@1,1)4(2
:herefore, $V =@1,1)4(2 6 @10/(2/ = @1,0/6(*'

A !o"e *essi!isti$ fo"e$ast
:ime 0 1 2 ' 4 !
et cash flows 6*00 *6(6/ 111(/ 116(6/ 21 20
Aiscount factor 1 0()//2 0(/6*! 0(6/!1 0(!*21 0(!1*4
Aisc cash flows 6*00 )4()0 )!(*! /)(/6 612(4'
$V for Bears 0 to 4 = 6*00 3 )4() 3 )!(*! 3 /)(/6 5 12(4' = 6662(*2
$erpetuit% from %ear !
= 20 = @142()6
0(14
$erpetuit% from %ear 0 = 142()6 . 0(!*21
=@)4(!*
:herefore, $V =@)4(!* 6 @662(*2 = 6@!/)(''
8

E-*e$te# NPV 3 4NPV
a
P
a
C = ,1') . 0(!- 3 ,10// . 0('- 3 ,6!/) . 0(2-
= 6* 3 '2'(1 3 ,611!(6-
= @2/6(!m
Stan7ar7 Aeviation = D,$V
i
6 $V-E $F
$V $F $V # $F $V6 C ,$V6 C-E ,$V6$V-E $F
1') 0(! 6*(0 61')(! 1*,1)2(2! *,!*1
1,0// 0(' '2'(1 )00(! 640,)00(2! 1*2,240
6!/) 0(2 611!(6 6)!4(! /'0,1/0(2! 146,0'4
G#pecte7 $V ,C- 2/6(! '4/,)6!
Stan7ar7 Aeviation ,H- = '4/,)6!
=@!)*()
=@!*0
%. I = . 5 C
H
Jhere
I is the number of stan7ar7 7eviations from the mean
. is the outcome that %ou are concerne7 about
K is the mean of the possible outcome
H is the stan7ar7 7eviation of the outcome 7istribution

9
. = 6!!0 H = !*0 C = 2/6(!

I = 6 !!0 5 2/6(! = 61(4 see "ppen7i# V ,ormal Aist( :ables-
!*0
= 41(*2&
:herefore,
$robabilit% of avoi7in; li8ui7ation = 41(*2& 3 !0&
= *1(*2&
$. I = . 5 C
H
. = 100 H = !*0 C = 2/6(!
I = 100 6 2/6(! = 0(' ,ormal Aist :able-
!*0
= 11(/*&
:herefore,
$robabilit% of a rapi7l% movin; share price = 11(/*& 3 !0&
= 61(/*&
10
QUESTION 5 PEN6UIN Pl$.
7a, Co+si#e" )(at Pe+.i+ s(ol# #o )it( "es*e$t to t(is S**lie"
In ths partcuar case two optons are opened to Pengun n decdng whether
or not to take advantage of the suppers new oher.

Option 1 s to pay on the 7
th
day foowng devery and earn 2% on the
purchase.
Monthy purchases 800,000 at 2% w yed 16,000 per month
Dscount on 12 months purchases w be 16,000 X 12 = 192,000
Option 2 s to pay after 70 days.
Snce Pengun s aready runnng an overdraft whch attracts nterest at 15%,
t means that f the company coud take more money from the Bank nterest
charges woud rse.
To get how much they are savng now by en|oyng the credt factes from
ther suppers as aganst the new dea?
Days ganed 63 .e. 70 days - 7 days
63 X 15 X 800,000 = 20,712
365 100
Tweve months purchase = 20,712 X 12 = 248,544
The anayss therefore shows that t w be better to en|oy the trade credt
factes rather than ncreasng the companys overdraft facty. Ths means
that when materas are devered to Pengun for use n ts producton they
are not pad for mmedatey. These materas w then be used to produce
ncome before the nvoce has to be pad.
Pengun s therefore advsed to choose the second opton, .e. contnue to pay
on the 70
th
day.
11
Ths stand can aso be proved by the fact that n percentage terms, the cost
of borrowng over 63 days s 2.59, .e.
63 X 15 = 2.59%
365 100
Ths s hgher than the 2% dscount ohered by the supper.
b)
Liquidity
The company has a very serous qudty probem. The qudty rato s the
most commony used measure of short-term sovency, snce t ndcates the
extent to whch the cams of short-term credtors are covered by assets that
are expected to be converted nto cash n a perod roughy correspondng to
the maturty of the cams. The cacuaton s:-
Current Rato = Current Assets
Current Labtes
Penguns current rato stands at -2.1.
The quck rato, whch s cacuated by deductng nventores from current
asset and dvdng the remander by current abtes, stands at -3.8.
Inventores are typcay the east qud of a rms current assets and the
assets on whch osses are most key to occur n the event of qudaton.
Therefore, ths measure of the rms abty to pay oh short-term obgatons
wthout reyng on the sae of nventores s mportant.
Business Activity and Cash Management
Pengun must serousy mprove upon the management of ts qud resources.
Cash s often caed a "non-earnng asset". It s needed to pay for abour and
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raw materas, to buy xed etc. The goa of the cash management s to
mnmze the amount of cash the rm must hod for use n conductng ts
norma busness actvtes, yet at the same tme, to have sumcent cash:
. to take advantage of trade dscounts
. to mantan ts credt ratng and
. to meet unexpected cash needs.
Frms typcay foow a cyce n whch they purchase nventory, se goods on
credt, and then coect accounts recevabe. Ths cyce s referred to as the
cash converson cyce. Some workng capta pocy s desgned to mnmze
the tme between cash expendtures on materas and the coecton of cash
on saes.
Cash converson cyce nets out three perods:
. Inventory converson perod whch s the average tme requred to
covert materas nto nshed goods and then to se those goods.
. Recevabe coecton perod, whch s the average ength of tme
requred to convert the rms recevabes nto cash; .e. to coect cash
foowng a rate
. Payabe deferra perod whch s the average ength of tme between
the purchase of materas and abour and the payment for cash.
The rms goas shoud be to shorten ts cash converson cyce as much as
possbe wthout hurtng operatons. To mprove upon the companys cash
ows Pengun shoud am at shortenng cash converson cyce by:
. Reducng nventory converson perod by processng and seng goods
more qucky
. Reducng the recevabe coecton perod by speedng up coecton
. If possbe engthenng the payabe refusa perod by sowng down
further the rms own payments.
These recommendatons are desrabe ony to the extent that these actons
can be taken wthout ncreasng cost or depressng saes.
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An mprovement n the cash ow poston w enhance the workng capta.
Furthermore, the mprovement n cash ow w get rd of the ma|or drawback
to an overdraft as the bank retans the rght to wthdraw the facty at short
notce.
Proftabiity and Capita !earing
The return on nvestment (ROI) s commendabe. If the nterest on overdraft s
15% t means that nvestng n any nanca nstrument may be far ower
than the return on nvestment of 30%.
That beng the case t w be attractve to nvest n Pengun Pc. However the
capta gearng s ow. The Equty to Debt rato s 1:2.6. Reatvey heavy
reance on credt ohers both advantages and dsadvantages.
Advantages:
. The rate of nterest on oans may be ower than the rate of return on
the pro|ect (as n the present case), thus ncreasng the actua rate of
return due to equty.
. Snce nterest s charged aganst prots, ess tax s pad and actua rate
of return due to equty s ncreased.
Dsadvantages:
. Interest charges, whch are costs, are xed and due for payment
whether prots are made or not.
. Equty eaves management ndependent (to an extent) whe credtors
can nterfere wth managements programme.
It shoud be noted that there s no rue for an dea debt/equty rato. Each
pro|ect or aternatves of a set of pro|ects must be consdered on ther own
merts n the context of ndustry requrements and prevang crcumstances.
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Because of the ow gearng and the serous qudty probems faced by
Pengun t s further recommended that n addton to prudent cash
management the owners shoud consder n|ectng more equty capta nto
the busness to ensure stabty and contnuty.
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