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Capital Expenditure Decision

### Question 1: Capstaff Ltd: A Capital Expenditure Decision Capstaff Ltd is a relatively small engineering company that manages to compete effectively with larger companies by adapting to changing market requirements and specialising in innovative products with limited markets. The products are sold to a wide range of companies, but most of its sales are to companies in the oil industry. On this basis it has maintained a high rate of return on capital employed in relation to the engineering sector as a whole. The latest product to be developed, a high pressure valve, has completed its testing stage and the company now has to decide on whether or not to invest in a production facility and a marketing programme. The work already undertaken on the product has cost £1.3 million and it is anticipated that some further development work will cost a further £0.2 million. It is estimated that an investment of £9.00 million will be necessary in plant and machinery. This expenditure can be written off (capital allowances) for tax purposes on a straight-line basis over the product's expected six year life. It is anticipated that the re-sale value of the equipment will be about £2.00 million at the end of the six years. The outlay would have been larger, but the company already owns some finishing equipment that will be required. This was previously used in the manufacture of another product that is no longer being produced. It is fully depreciated for tax purposes and could be sold today for £180,000. If used for the next six years it will have no resale value. The production facility would be located in one of the company's factories with spare capacity available. It will occupy 15 per cent of the factory's space. The company has no alternative uses available for this space for the foreseeable future and has further spare capacity available in other factories. The product will be charged £50,000 per annum for this space by the company's management accounting system, though only 20 per cent of this figure will stem from incremental costs resulting from heating and lighting. The fixed costs directly attributable to the production are expected to be £ 90,000 per annum. Each product sold by the company is also allocated a general overhead charge equivalent to 10 per cent of the revenues it generates. This allocation is made by the company's accountant to cover head office expenses. The selling price is expected to be set at £38.00 per unit and it is anticipated that sales in the first year will be about 150,000 units, rising to 200,000 in year two, and staying at this level for the following four years. The introduction of the product would require a marketing campaign that will cost £150,000. As a result of the rapid technological development in the area a six year product life is all that can be expected. The direct manufacturing costs are expected to be £12.00 per unit. The company will need to hold stocks of the product at the start of each year equivalent to 25 per cent of the sales expected in the year to come. The increase in debtors as a result of introducing the product will be just about offset by the increase in creditors. The company requires a rate of return of 14 per cent on investments of this nature, and the tax rate is 40 per cent. -Determine the investment's net present value and the internal rate of return. All key assumptions should be specified and explained. (10 MARKS -Undertake a sensitivity analysis for the assumed price and volume of expected sales and interpret your results carefully. (5 MARKS) -Provide a brief general discussion of the potential risks associated with this investment. (5 MARKS) ------------------------------------------------------------------------------------------------------------------------------------------------Question 2: Valuation of a Company's Shares Take the price earnings ratios for three companies traded on the London Stock Exchange from the data set in the attached file. These companies are drawn from the FT 100, the hundred largest companies traded on the exchange, and the P/E ratios specified are for the end of each year from 2007 to 2013. The data also gives the P/E ratios for the index. Discuss the factors that might explain the differences in the price earnings ratios of the three companies you have chosen and the changes that have occurred in their price earnings ratios over the six year period. (Choose companies with a range of P/E ratios to give you one with a relatively low value, one with a relatively high value, and another with a middling value.) You should use the insights provided by valuation models on the determinants of the price-earnings ratios in your discussion, but you should also discuss the role of any other factors that might influence the reported values of price-earnings ratios of the companies you have chosen. Whilst you need to gather some information on the companies you choose it is not anticipated that you undertake an in-depth analysis of the companies. It is acceptable to make use of some possible reasons to account for the differences in the price earnings ratios as well as employing the information that you gather on the companies. (20 MARKSQuestion 3: Portfolio Analysis The attached file (Stock returns 2007-14) gives 68 monthly returns for securities drawn from the FT ALL Share Index for the period January 2007 and December 2014. a) i. The data set provided identifies four equally weighted portfolios of one, five, ten, and fifteen securities. Determine, using the appropriate Excel function (see fx)) the standard deviation and variances of the monthly returns for each of the companies included in the portfolios. (Use the 84 months returns data in the calculations and use the Excel functions identified as Variance.P and Standard Deviation P.) Next determine the monthly returns on the four portfolios along with the standard deviation of these returns. The monthly portfolio returns are simply the average of the monthly returns for each security included in the portfolio. Compare the average value of the standard deviations of the returns on the securities included in each portfolio with the standard deviation of portfolio's returns. Comment on the difference between the outcomes. Discuss the consequences of increasing the number of securities in the portfolios. Compare your results to those of the studies of naïve diversification. (8 MARKS)ii. Determine the variance of each security and the co-variances for each pair of securities in the portfolio of five securities using the relevant Excel function. Employ this information to calculate the standard deviation of the returns on the portfolio using the equally weighted portfolio risk equation. Compare your results to those obtained for the portfolio in part i above. (4 MARKS)Determine the betas for SSE (Scottish and Southern Energy), a utility company, and Barratt Developments, a construction company, by regressing the returns for each of the two companies on the returns for the FT ALL Share Index (the first column in the spread-sheet). i. Explain what the values of the betas (the slope coefficients in the regression) indicate and discuss the factors that might explain the differences in the values of the betas of the two companies. ii. Comment on the implications of the estimated value of beta for investors and the cost of capital for the two companiesQuestion 4 This question concerns Alibaba the internet e-commerce firm that recently went public. It is an open ended question that requires you to utilize the valuation techniques you have learnt in the course and also to do independent research. a) Research Alibaba's business model, particularly its sources of revenue and its profit margins. What sort of revenue growth do you think it will be able to maintain in the next ten years? Do you think it will be able to maintain its current profit margins? b) Study the attached valuation spreadsheet. Input your predicted revenue growth rates and profit margins to come up with your valuation of Alibaba. You could use a range of values and also do a sensitivity analysis. c) How does your range of valuations compare the valuations based on the recent movements of the Alibaba share price? What do the current share price movements tell you about the market's estimations of Alibaba's prospects?

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