we have to complete total of 5 questions out of 7
1. Time Value of money – investment criteria a) You are planning to retire in 25 years time. Immediately after your retirement, you wish to go for a round the world trip lasting one year. Your monthly expenses for the trip work out to be £9000 and the first withdrawal will be made at the end of the month after your retirement. You also want to provide yourself with £35,000 a year for next 15 years on your return from the world trip. How much you should save every month to provide for the above if the effective rate of interest is 14% per annum. (4 marks) b) Your firm has a retirement plan that matches all employee contributions with employer contributions on a two-to-one basis. That is if an employee contributes £1,000 per year, the company will add £2,000 to make the total contribution £3,000. The firm guarantees a fixed 6 per cent return on the funds. Alternatively, you can provide for retirement yourself, and you think you can earn 9 per cent on your money. The first contribution will be made one year from today. At that time and every year thereafter, you will put £2,500 into the retirement account, the same amount as you would have contributed to the company pension fund. You plan to retire in 30 years. Are you going to be better off participating in the company scheme or making your own arrangements? Explain the basis of your answer (ignore any tax considerations). (3 marks) c) The manager responsible for the pension fund of Ruthin plc has to present a report to the Board of Directors on the financial position of the fund. He decides to use the position of the typical employee to illustrate the fund’s position. There is £30,000 currently held in the fund for each employee. The typical employee has 15 years to go to retirement and the company’s actuary has proposed that the company should anticipate having to fund pension payments over a retirement period of 12 years for the average employee. The average pension payment per annum is expected to be £12,000 and the rate of return expected on the pension funds investment is expected to be 6 per cent. The manager needs to determine the constant annual sum that the company needs to put into the pension fund for each of the next 15 years to be able to meet the fund’s obligations. Determine this annual sum. (Assume all payments into the fund and all pension payments are made at the end of each year.) (3 marks) d) Explain what is meant by the internal rate of return of an investment and discuss its relationship to the NPV of an investment. (4 marks) e) Explain the problems posed for the use of the IRR when it is necessary (i) to choose between two investments and when (ii) investments are characterised by negative net cash flows at the end of their lives. (3 marks) f) Discuss and evaluate the use of the payback period as an investment criterion. (3 marks) (TOTAL 20 MARKS) 2.Capital Expenditure Decisions and Investment Criteria Raindeer plc Raindeer PLC is a highly profitable electronics company that manufactures a range of innovative products for industrial use. Its success is based to a large extent on the ability of the company’s development group to generate new ideas that result in commercially viable products. The latest of these products is just about to undergo some final tests and a decision has to be taken whether or not to proceed with an investment in the facilities required for manufacturing. You have been asked to undertake an evaluation of this investment. The company has already spent £750,000 on the development of this product. The final testing of the product will cost about £40,000. The head of the development group is very confident that the tests will be successful based on the work already undertaken. Another company has already offered Raindeer £1.10 million for the product’s patent and an exclusive right to its manufacture and sale, even though the final tests are still to be completed. This sum being offered is well in excess of the cost of the product’s development, but the company’s management have decided to delay their response to the offer until the result of the investment evaluation is available. The company anticipates that the product will remain competitive for the next five years after which it is likely to be displaced by some new product that are constantly being introduced as the underlying technology evolves. In the first year it is anticipated that 35,000 units will be sold at a price of £152. From year two through to year four sales are expected to be 45,000 units per annum, but are expected to fall back to 35,000 units in year five. The product will be manufactured in one of the company’s factories that has considerable spare capacity: it is most unlikely that the space required by the manufacture of this product will be required for any other purpose over the next five years. For the company’s internal accounting purposes all products are charged for the factory space that they utilise and this will amount to £50,000 per annum. The additional costs incurred by the company in the form of heating, lighting and power only amount to £30,000 per annum. The machinery required for the manufacture of the product will cost £1,200,000. It will have to be depreciated for tax purposes on the basis of an annual 25 per cent writing down allowance (ie. 25 per cent of the remaining book value of the asset, the initial purchase price less the sum of the allowances claimed in previous years). At the end of the five year period the machinery will be sold or retained for use in the manufacture of other products. The resale value of machinery of this nature after being used for five years is likely to be about 30 per cent of its purchase price. Use will also be made of some equipment already owned by the company. This could be sold today for £70,000 and is expected to maintain its resale value even if it is used for the next five years. This equipment is fully depreciated for tax purposes – it has a zero book value – but is still in good working order. The cost of the labour and components required for the manufacture of the product has been estimated at £120 per unit for the first year, with labour accounting for 60 per cent of the cost and the components for the other 40 per cent. There are also fixed costs of £150,000 per annum stemming from the manufacturing process. The product will also be charged an allowance for general overheads through the management accounting system and this is set at 5 per cent of a product’s annual revenues. The overheads include the head office expenditure and the company’s expenditure on new product development – an important expense for the company. The initial marketing of the product will cost £200,000. It is anticipated that the company will have to invest in working capital – holding finished products equivalent to 20 per cent of next year’s unit sales, 25 per cent of the components required for the next year, and it is expected that debtors and creditors will just about offset each other. The tax