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:
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Process Omega
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|
|
|
|
|
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Year
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0
|
1
|
2
|
3
|
4
|
|
After-tax cash flows ($000)
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(3,800)
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1,220
|
1,153
|
1,386
|
3,829
|
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Process Zeta
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|
|
|
|
|
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Year
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0
|
1
|
2
|
3
|
4
|
|
After-tax cash flows ($000)
|
(3,800)
|
643
|
546
|
1,055
|
5,990
|
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:
(a) Provide a reasoned estimate of the cost of capital that Tisa Co should use to calculate the net present value of the two processes. Include all relevant calculations.
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.
Elfu Co has estimated an annual standard deviation of $800,000 on one of its other projects, based on a normal distribution of returns. The average annual return on this project is $2,200,000.
Required:
Estimate the project's Value at Risk (VAR) at a 99% confidence level for one year and over the project's life of five years. Explain what is meant by the answers obtained.