2 Fubuki Co,an unlisted company based in Megaera,has been manufacturing electrical parts used in mobility vehicles for people with disabilities and the elderly,for many years.These parts are exported to various manufacturers worldwide but at present there are no local manufacturers of mobility vehicles in Megaera.Retailers in Megaera normally import mobility vehicles and sell them at an average price of $4,000 each.Fubuki Co wants to manufacture mobility vehicles locally and believes that it can sell vehicles of equivalent quality locally at a discount of 37·5% to the current average retail price.

　　Although this is a completely new venture for Fubuki Co,it will be in addition to the company‘s core business. Fubuki Co's directors expect to develop the project for a period of four years and then sell it for $16 million to a private equity firm.Megaera‘s government has been positive about the venture and has offered Fubuki Co a subsidised loan of up to 80% of the investment funds required,at a rate of 200 basis points below Fubuki Co's borrowing rate.Currently Fubuki Co can borrow at 300 basis points above the five-year government debt yield rate.

　　A feasibility study commissioned by the directors,at a cost of $250,000,has produced the following information.

　　1.Initial cost of acquiring suitable premises will be $11 million,and plant and machinery used in the manufacture will cost $3 million.Acquiring the premises and installing the machinery is a quick process and manufacturing can commence almost immediately.

　　2.It is expected that in the first year 1,300 units will be manufactured and sold.Unit sales will grow by 40% in each of the next two years before falling to an annual growth rate of 5% for the final year.After the first year the selling price per unit is expected to increase by 3% per year.

　　3.In the first year,it is estimated that the total direct material,labour and variable overheads costs will be $1,200 per unit produced.After the first year,the direct costs are expected to increase by an annual inflation rate of 8%.

　　4.Annual fixed overhead costs would be $2·5 million of which 60% are centrally allocated overheads.The fixed overhead costs will increase by 5% per year after the first year.

　　5.Fubuki Co will need to make working capital available of 15% of the anticipated sales revenue for the year,at the beginning of each year.The working capital is expected to be released at the end of the fourth year when the project is sold.

　　Fubuki Co's tax rate is 25% per year on taxable profits.Tax is payable in the same year as when the profits are earned.Tax allowable depreciation is available on the plant and machinery on a straight-line basis.It is anticipated that the value attributable to the plant and machinery after four years is $400,000 of the price at which the project is sold. No tax allowable depreciation is available on the premises.

　　Fubuki Co uses 8% as its discount rate for new projects but feels that this rate may not be appropriate for this new type of investment.It intends to raise the full amount of funds through debt finance and take advantage of the government‘s offer of a subsidised loan.Issue costs are 4% of the gross finance required.It can be assumed that the debt capacity available to the company is equivalent to the actual amount of debt finance raised for the project.

　　Although no other companies produce mobility vehicles in Megaera,Haizum Co,a listed company,produces electrical-powered vehicles using similar technology to that required for the mobility vehicles.Haizum Co‘s cost of equity is estimated to be 14% and it pays tax at 28%.Haizum Co has 15 million shares in issue trading at $2·53 each and $40 million bonds trading at $94·88 per $100.The five-year government debt yield is currently estimated at 4·5% and the market risk premium at 4%.

　　Required：

　　（a）Evaluate， on financial grounds， whether Fubuki Co should proceed with the project. （17 marks）

　　（b）Discuss the appropriateness of the evaluation method used and explain any assumptions made in part （a）above. （8 marks）

　　（25 marks）

　　Section B - TWO questions ONLY to be attempted

　　3 The treasury division of Marengo Co,a large quoted company,holds equity investments in various companies around the world.One of the investments is in Arion Co,in which Marengo holds 200,000 shares,which is around 2% of the total number of Arion Co's shares traded on the stock market.Over the past year,due to the general strength in the equity markets following optimistic predictions of the performance of world economies,Marengo's investments have performed well.However,there is some concern that the share price of Arion Co may fall in the coming two months due to uncertainty in its markets.It is expected that any fall in share prices will be reversed following this period of uncertainty.

　　The treasury division managers in Marengo,Wenyu,Lola and Sam,held a meeting to discuss what to do with the investment in Arion Co and they each made a different suggestion as follows:

　　1.Wenyu was of the opinion that Marengo's shareholders would benefit most if no action were taken.He argued that the courses of action proposed by Lola and Sam,below,would result in extra costs and possibly increase the risk to Marengo Co.

　　2.Lola proposed that Arion Co's shares should be sold in order to eliminate the risk of a fall in the share price.

　　3.Sam suggested that the investment should be hedged using an appropriate derivative product.

　　Although no exchange-traded derivative products exist on Arion Co's shares,a bank has offered over-the-counter （OTC）

　　option contracts at an exercise price of 350 cents per share in a contract size of 1,000 shares each,for the appropriate time period. Arion Co's current share price is 340 cents per share,although the volatility of the share prices could be as high as 40%.

　　It can be assumed that Arion Co will not pay any dividends in the coming few months and that the appropriate inter-bank lending rate will be 4% over that period.

　　Required:

　　（a）Estimate the number of OTC put option contracts that Marengo Co will need to hedge against any adverse movement in Arion Co's share price. Provide a brief explanation of your answer.

　　Note:You may assume that the delta of a put option is equivalent to N（） （7 marks）

　　（b）Discuss possible reasons for the suggestions made by each of the three managers. （13 marks）

　　（20 marks）

　　4 Lamri Co（Lamri）,a listed company,is expecting sales revenue to grow to $80 million next year,which is an increase of 20% from the current year.The operating profit margin for next year is forecast to be the same as this year at 30% of sales revenue. In addition to these profits,Lamri receives 75% of the after-tax profits from one of its wholly owned foreign subsidiaries – Magnolia Co（Magnolia）,as dividends.However,its second wholly owned foreign subsidiary – Strymon Co（Strymon）does not pay dividends.

　　Lamri is due to pay dividends of $7·5 million shortly and has maintained a steady 8% annual growth rate in dividends over the past few years.The company has grown rapidly in the last few years as a result of investment in key projects and this is likely to continue.

　　For the coming year it is expected that Lamri will require the following capital investment.

　　1.An investment equivalent to the amount of depreciation to keep its non-current asset base at the present productive capacity.Lamri charges depreciation of 25% on a straight-line basis on its non-current assets of $15 million.This charge has been included when calculating the operating profit amount.

　　2.A 25% investment in additional non-current assets for every $1 increase in sales revenue.

　　3.$4·5 million additional investment in non-current assets for a new project.

　　Lamri also requires a 15% investment in working capital for every $1 increase in sales revenue.Strymon produces specialist components solely for Magnolia to assemble into finished goods.Strymon will produce 300,000 specialist components at $12 variable cost per unit and will incur fixed costs of $2·1 million for the coming year.It will then transfer the components to Magnolia at full cost price,where they will be assembled at a cost of $8 per unit and sold for $50 per unit.Magnolia will incur additional fixed costs of $1·5 million in the assembly process.

　　Tax-Ethic（TE）is a charitable organisation devoted to reducing tax avoidance schemes by companies operating in poor countries around the world.TE has petitioned Lamri's Board of Directors to reconsider Strymon's policy of transferring goods at full cost.TE suggests that the policy could be changed to cost plus 40% mark-up.If Lamri changes Strymon‘s policy,it is expected that Strymon would be asked to remit 75% of its after-tax profits as dividends to Lamri.

　　Other Information

　　1.Lamri's outstanding non-current liabilities of $35 million,on which it pays interest of 8% per year,and its 30 million $1 issued equity capital will not change for the coming year.

　　2.Lamri's,Magnolia's and Strymon‘s profits are taxed at 28%,22% and 42% respectively.A withholding tax of 10% is deducted from any dividends remitted from Strymon.

　　3.The tax authorities where Lamri is based charge tax on profits made by subsidiary companies but give full credit for tax already paid by overseas subsidiaries.

　　4.All costs and revenues are in $ equivalent amounts and exchange rate fluctuations can be ignored.

　　Required：

　　（a）Calculate Lamri‘s dividend capacity for the coming year prior to implementing TE's proposal and after implementing the proposal. （14 marks）

　　（b）Comment on the impact of implementing TE's proposal and suggest possible actions Lamri may take as a result. （6 marks）

　　（20 marks）