ACCA AFM Syllabus B. Advanced Investment Appraisal - MIRR - Past Papers ^{14 / 14}

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)

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:
(b) Calculate the figures which have not been provided for project Drugi and recommend which project should be accepted. Provide a justification for the recommendation and explain what the value at risk measures. (13 marks)

Tisa Co is considering an opportunity to produce an innovative component which, when fitted into motor vehicle engines, will enable them to utilise fuel more efficiently. The component can be manufactured using either process Omega or process Zeta.

Although this is an entirely new line of business for Tisa Co, it is of the opinion that developing either process over a period of four years and then selling the productions rights at the end of four years to another company may prove lucrative.

The annual after-tax cash flows for each process are as follows:

Tisa Co has 10 million 50c shares trading at 180c each. Its loans have a current value of $3•6 million and an average after-tax cost of debt of 4•50%. Tisa Co’s capital structure is unlikely to change significantly following the investment in either process.

Elfu Co manufactures electronic parts for cars including the production of a component similar to the one being considered by Tisa Co. Elfu Co’s equity beta is 1•40, and it is estimated that the equivalent equity beta for its other activities, excluding the component production, is 1•25. Elfu Co has 400 million 25c shares in issue trading at 120c each.

Its debt finance consists of variable rate loans redeemable in seven years. The loans paying interest at base rate plus 120 basis points have a current value of $96 million. It can be assumed that 80% of Elfu Co’s debt finance and 75% of Elfu Co’s equity finance can be attributed to other activities excluding the component production.

Both companies pay annual corporation tax at a rate of 25%. The current base rate is 3•5% and the market risk premium is estimated at 5•8%.

Required:

Calculate the internal rate of return (IRR) and the modified internal rate of return (MIRR) for Process Omega. Given that the IRR and MIRR of Process Zeta are 26•6% and 23•3% respectively, recommend which process, if any, Tisa Co should proceed with and explain your recommendation. (8 marks)