QUESTION 1 a) This is a two period certainty model problem. Assume that William Brown has a sole…

QUESTION 1

a) This is a two period certainty model problem.

Assume that William Brown has a sole income from Bobcat Ltdin which he owns 12% of the ordinary share capital.

In its financial year 2016-17 just ended, Bobcat Ltd reported net profits after tax of $600,000, and announced its net profits after tax expectation for the next financial year, 2017-18, to be 25% higher than this year's figure. The company operates with a dividend payout ratio of 70%, which it plans to continue, and will pay the annual dividend for 2016-17 in mid-August, 2017, and the dividend for 2017-18 in mid-August, 2018.

In mid-August, 2018, Jack wishes to spend $100,000, which will include the cost of a new car.. How much can he consume in mid-August, 2017 if the capital market offers an interest rate of 9% per year?

b) This question relates to the valuation of shares.

Big Ideas Ltd has just paid a dividend of $1.20 a share. Investors require a 12% per annum return on investments such as Big Ideas. What would a share in Big Ideas Ltd be expected to sell for today (August, 2017) if the dividend is expected to increase by 20% in August, 2018, 15% in August, 2019, 10% in August, 2020 and thereafter by 5 per cent a year forever, from August, 2021 onwards?

QUESTION 2

This question relates to capital budgeting.

Perth Projects Ltdis considering the purchase of new technology costing $600,000, which it will fully finance with a fixed interest loan of 10% per annum, with the principal repaid at the end of 4 years.

The new technology will permit the company to reduce its to reduce its labour costs by $200,000 a year for 4 years, and the technology may be depreciated for tax purposes by the straight-line method to zero over the 4 years. The company thinks that it can sell the technologyat the end of 4 years for $30,000.

The technology will need to be stored in a building, currentlybeing rented out for $40,000 a year under a lease agreement with 4 yearlyrental payments to run, the next one being due at the end of one year. Under the lease agreement, Perth Projects Ltd can cancel the lease by paying the tenant (now) compensation equal to one year's rental payment plus 10%, but this amount is not deductible for income tax purposes.

This is not the first time that the company has considered this purchase. Twelve monthsago, the company engaged Marvel Consultants, at a fee of $30,000 paid in advance, to conduct a feasibility study on savings strategies and Marvel made the above recommendations. At the time, Perth P:rojectsdid not proceed with the recommended strategy, but is now reconsidering the proposal.

Perth Projects further estimates that it will have to spend $20,000 in 2 years' time overhauling the technology. It will also require additions to current assets of $30,000 at the beginning of the project, which will be fully recoverable at the end of the fourth year.

Perth ProjectsLtd'scost of capital is 10%. The tax rate is 30%. Tax is paid in the year in which earnings are received.

REQUIRED:

(a) Calculate the net present value (NPV), that is, the net benefit or net loss in present value terms of the proposed purchase costs and the resultant incremental cash flows.

[HINT: As shown in the text-book, it is recommended that for each year you calculate the tax effect first, then identify the cash flows, then calculate the overall net present value.]

(b) Should the company purchase the technology? State clearly why or why not.