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Question 3a

Riviere Co is a small company based in the European Union (EU). It produces high quality frozen food which it exports to a small number of supermarket chains located within the EU as well. The EU is a free trade area for trade between its member countries.

Riviere Co finds it difficult to obtain bank finance and relies on a long-term strategy of using internally generated funds for new investment projects. This constraint means that it cannot accept every profitable project and often has to choose between them.

Riviere Co is currently considering investment in one of two mutually exclusive food production projects: Privi and Drugi. Privi will produce and sell a new range of frozen desserts exclusively within the EU. Drugi will produce and sell a new range of frozen desserts and savoury foods to supermarket chains based in countries outside the EU. Each project will last for five years and the following financial information refers to both projects.

Project Drugi, annual after-tax cash flows expected at the end of each year (€000s)

Year Current 1 2 3 4 5
Cash flows (€000s) (11,840) 1,230 1,680 4,350 10,240 2,200
Privi Drugi
Net present value €2,054,000 €2,293,000
Internal rate of return 17·6% Not provided
Modified internal rate of return 13·4% Not provided
Value at risk (over the project’s life)
95% confidence level €1,103,500 Not provided
90% confidence level €860,000 Not provided

Both projects’ net present value has been calculated based on Riviere Co’s nominal cost of capital of 10%. It can be assumed that both projects’ cash flow returns are normally distributed and the annual standard deviation of project Drugi’s present value of after-tax cash flows is estimated to be €400,000. It can also be assumed that all sales are made in € (Euro) and therefore the company is not exposed to any foreign exchange exposure.

Notwithstanding how profitable project Drugi may appear to be, Riviere Co’s board of directors is concerned about the possible legal risks if it invests in the project because they have never dealt with companies outside the EU before.

Required:
(a) Discuss the aims of a free trade area, such as the European Union (EU), and the possible benefits to Riviere Co of operating within the EU. (5 marks)