Question 1
Toys Ltd currently has one product on the market, which has been extremely successful
The company is developing a new advanced model – the Matsue.
To date, €220,000 has been spent on developing the product and has also incurred €150,000 in market research costs, although the invoice for these costs has only just been received and will be paid in January. A final decision now needs to be made as to whether it is viable to
manufacture and sell Matsue.
The following revenues and costs have been estimated:
A new factory, to be used solely for the production of Metsue will need to be built. This will take nearly a year to build and is expected to cost €10·75 million in total, payable in two installments – €5m now in advance of the start of the building work and the remainder will be paid when the building work is completed at the end of the first year.
Toys Ltd will immediately enter into a one-year contract with a project management company, which will oversee the building of the factory. The cost of €250,000 will be paid when the building is completed. Two production lines will need to be installed in the factory at a further cost of €1.5m. payable in one year’s time.
Machinery also needs to be built-to-order and is expected to cost €2·5m, payable in one year’s time. It will have a nil value at the end of the project. Depreciation will be charged as soon as production commences (in one year’s time) at 10% per annum on a straight-line basis.
Maintenance costs for the machinery are estimated at €250,000 per annum starting in year 2.
Production and Sales as well as related costs will commence in year 2. Sales quantities and prices are expected to be as follows:
It is anticipated that there will be no further sales after these dates.
Material costs are estimated at €125 per unit.
Labor costs are estimated at €100 per unit.
Fixed production overheads relating to the new factory are estimated at €240,000 per annum. Variable production overheads are expected to be €50 per unit.
Head office costs of €2·5m per annum will be allocated to Metsue when production commences. Of these costs, only €1·7m is incremental.
The company’s cost of capital is 10%.
Assume that all cash flows occur at the end of the year, unless stated otherwise.
All workings should be in €’000.
Question 2
Describe the difference between systematic and unsystematic risk?
Two companies DK plc and P plc have the following details.
Their Beta values market return and risk-free rate are as follows:
The market return is 15%
The risk-free is 5%
(i) Calculate the required investor return for both companies.
The Traditional View and MM (Modigliani & Miller) views on the impact of gearing on WACC (Weighed Average Cost of Capital) have created a lot of debate over the years. Briefly outline the Traditional View and MM, also draw and label the relevant three graphs to illustrate your answer.
