BANK 2007 Business Finance XXXXXXXXXX XXXXXXXXXX Question a: Specify whether the evaluation of Oz-seafoods Ltd’s capital budgeting projects should be undertaken on a pre-tax or after-tax basis. Answer: Oz-seafoods Limited is an Australian Stock Exchange listed company but 88 % of its ordinary shareholders are from the USA and Canada…
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This imposes limitation on the company to use Australian Tax though major shareholders are non-Australian. OZ – Seafood Limited, according to the Australian Tax law, is classified as Category 1 Company. Company’s capital budgeting projects should be undertaken on pre – tax basis, as recommended by the Australian Tax Regulation . Question b: Over how many years should Oz-seafoods’ capital budgeting evaluation of the polystyrene container manufacturing proposal be undertaken Answer: Machinery for manufacturing polystyrene containers has 10 years operational life with no salvage value. According to the Federal Laws, company can deprecate total cost of the machine on a straight-line basis over seven years. Capital budgeting evaluation should be undertaken over 7 years of time. However, that will give salvage value, which will be taxable. Question c: Do you agree or disagree with the accountant’s argument regarding the working capital outlay being ignored in the evaluation of the capital budgeting project? Answer: I disagree. Working capital is project cash flow element. It has to be included in capital budgeting projects. Working capital in the cash flow model is considered to be an expense item. It is Tax-deductible. By including it, company benefits. At the end of the project, working capital is recovered and added to cash flow as a net earning. However, before adding it to the cash flow, its present value is evaluated. NPV is thus adjusted by adding the present value of working capital. Question d: To determine the weighted average cost of capital that the company should use to evaluate its investment projects, calculate the appropriate measure of: (i) Cost of Debt (ii) Value of Debt (iii) Cost of Equity (iv) Value of Equity (v) Weighted Average Cost of Capital. Round your calculated answer to the nearest whole percentage (i) Cost of Debt calculation. Oz – seafoods has 5$ million current debt and 20 $ million long-term debts. The company should consider only long term debt for its investment projects. Cost of these bonds in the project is the rate of return has to be paid to the bond owners. This rate of return is named as Yield for the bond owners, and is the cost of debt for the company. The effective yield is calculated using the formula (Investing Answers): [1+ (r/n)] ^ n – 1; where: r = Normal rate n = number of payment in one year Long term bonds = 20 $ million Average maturity= 10 years. Average coupon rate, r = 10.7 % per annum , Number of payment in one year, (paid half yearly), n = 2 r/n = 0.107 / 2 = 0.0535 (1+0.0535)^2 – 1 = 0.10986 FV = 20,000,000 $ Coupon rate = 10.7 % Coupon PMT = 1,070,000 $ half yearly COMP i = 10.986 % = 11 % = 11 % Oz – seafoods’ economist has predicted an estimated 2 % inflation rate. With this adjustment, k D = 13 % The relationship between real rate and nominal rate is (Fisher formula): Rn = (1 + Rr)(1 + Ri) - 1 = Rr+ Ri+ RrRi (Nominal rate / Real rate calculator – Web.) Where, Rn is nominal rate, Rr is real rate and Ri is inflation rate. k D = k D = 0.02 + 0.11+ 0.11 * 0.02 = 0.1322 = 13.22 % = 13 % Note: 1. The current Yield rate on similar bonds is 9 % per annum. This is 6 % per annum above the government bonds with the same maturity. OZ – seafoods’ economist has predicted an average 7 % p.a. return above the government securities. The calculated value k D = 13 % consider this increase. 2. Oz –
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