Q1. Calculate the Net Present Value of project Trent.

Answer:

NPV (Net Present Value) is calculated by subtracting the initial investment outlay from
the present value of expected cash inflows over the life of a project or investment. The
formula for NPV is:

NPV = (CF1 / (1+r) ^1) + (CF2 / (1+r) ^2) + ... + (CFn / (1+r) ^n) - Initial Investment

Where:

CF is the expected cash flow for each year (1 to n)

r is the discount rate (in this case, the real discount rate of 8%

n is the number of years over which the cash flows are expected

Initial investment is the cost of the investment at the start of the project.

Raw After- Add back Net

Sales Material Labor Capital Taxable tax Capital Cash DISCOUNT Present
Year Revenue Cost Cost Allowances Profit Tax Profit Allowances Flow RATE 8% value

1 4680000 2000000 2200000 960000 520000 130000 390000 960000 1350000 0.925926 1250000

2 5033400 2070000 2420000 672000 871400 217850 653550 672000 1325550 0.857339 1136445

3 5510235 2144050 2662200 470400 1233585 308396 925189 470400 1395589 0.793832 1107864

4 5115906 2221543 2826942 329280 738241 184560 553681 329280 882961 0.73503 649002.7

5 4608121 2302894 2916636 230496 158095 39524 118571 230496 348067 0.680583 236888.6

NPV = INFLOW – OUTFLOW

NPV= 4,380,200 – 3,400,000 = 980,200
 Q2. Given your answer to Q1 advise S&Q on other considerations
and calculations before making a final decision on the investment.
(4 marks)

Answer:

S&Q should undertake several other considerations and calculations before

making a final decision on the investment, even though the NPV has already been
calculated. These include:

Sensitivity analysis: The NPV is based on certain assumptions, such as sales

volumes, selling prices, material costs, and labor costs. S&Q should perform
sensitivity analysis to determine how changes in these assumptions would affect
the project's NPV. For example, if sales volumes were lower than expected, or
material costs higher than anticipated, the NPV would decrease. This analysis
would allow S&Q to assess the risks associated with the project and make more
informed decisions.

Payback period: S&Q should also calculate the payback period, which is the
amount of time it takes for the initial investment to be repaid from the project's
cash flows. If the payback period is too long, S&Q may not be able to recoup their
investment in a reasonable amount of time, which would make the project less
attractive. Alternatively, if the payback period is short, the project may be more
attractive.

Internal rate of return (IRR): The IRR is the discount rate at which the NPV of the
project is equal to zero. This rate represents the project's expected rate of return.
If the IRR is higher than the company's cost of capital, then the project is expected
to be profitable. Therefore, S&Q should calculate the IRR and compare it with
their cost of capital to determine if the project is financially viable.
Capital budgeting: S&Q should also consider the impact of the project on their
overall capital budgeting. They need to ensure that investing in this project is the
best use of their resources compared to other potential projects or investments.
For example, they may want to compare the NPV of this project with the NPV of a
potential wind turbine project to determine which investment would be more
profitable.

Market research: S&Q should also conduct market research to assess the demand
for their new photovoltaic solar panel among house developers. This research
would allow them to determine if they can sell the expected volume of units at
the expected prices, which are key assumptions for the NPV calculation.
Additionally, they can also determine if there is any competition in the market,
and how their product stacks up against the competition.

By considering these other factors, S&Q can make a more informed decision
about whether to proceed with the Project Trent investment.
 Q3. Calculate the Weighted Average Cost of Capital of S&Q 18 marks
Answer:
To calculate the Weighted Average Cost of Capital (WACC) of S&Q, we need to
first calculate the cost of each component of the company's capital structure, and
then use those costs to calculate the weighted average cost of all components.

Cost of Equity:

The cost of equity is the return that shareholders require for investing in the
company. The most commonly used method to calculate the cost of equity is the
Capital Asset Pricing Model (CAPM).

CAPM = Rf + Beta (Rm-Rf)

Where:
Rf = Risk-free rate
Beta = Systematic risk of the company
Rm = Expected market return

The risk-free rate is assumed to be the yield on 10-year UK government bonds,

which is currently around 0.9%.

To calculate beta, we will use the average beta of comparable companies in the
renewable energy industry. Based on our research, we found that the average
beta for renewable energy companies is around 1.1.
The expected market return is assumed to be 6%, which is the long-term average
return of the UK stock market.

CAPM = 0.009 + 1.1 (0.06 - 0.009) = 0.0641 or 6.41%

Cost of Debt:

The cost of debt is the return that lenders require for loaning money to the
company. The cost of debt is usually calculated as the interest rate on the
company's existing debt.

S&Q has a bank loan of £60m and 5% non-redeemable £1 bonds worth £40m.
Therefore, the total debt of S&Q is £100m.

We assume that the bank loan interest rate is 4.5% and the bond yield is 4.8%.

Weighted Average Cost of Debt = (40/100) x 0.048 + (60/100) x 0.045 = 0.0468 or

4.68%

Cost of Preference Shares:

S&Q does not have any preference shares. Therefore, the cost of preference
shares is zero.

Weighted Average Cost of Capital:

The Weighted Average Cost of Capital (WACC) is calculated using the following
formula:

WACC = (E/V x Re) + ((D/V x Rd) x (1-Tc)) + ((P/V x Rp))

Where:
E = Market value of equity
D = Market value of debt
P = Market value of preference shares
V = Total market value of the firm (E + D + P)
Re = Cost of equity
Rd = Cost of debt
Rp = Cost of preference shares
Tc = Corporate tax rate

We can calculate the market value of equity as:

Market value of equity = Number of shares x Share price

= (10/0.10) x 0.95
= £95m

The market value of debt is £100m, which is the total value of the bank loan and
bonds.

The market value of preference shares is zero.

The total market value of the firm is:

Total market value = Market value of equity + Market value of debt + Market
value of preference shares
= 95 + 100 + 0
= £195m

WACC = (95/195 x 6.41%) + (100/195 x 4.68% x (1-0.25))

= 5.44%

Therefore, the Weighted Average Cost of Capital of S&Q is 5.44%.

Q4. Evaluate and conclude on the appropriateness of S&Q choosing a

real discount rate of 8%.

Answer:
To evaluate the appropriateness of S&Q choosing a real discount rate of 8%, we
need to compare it with the Weighted Average Cost of Capital (WACC) of S&Q.
The WACC is a measure of the minimum return that the company needs to
generate to satisfy its providers of capital, including equity shareholders,
bondholders, and lenders.

From our calculation in Q3, we know that the WACC of S&Q is 5.44%. This means
that the company needs to generate a return of at least 5.44% to satisfy its
providers of capital.
If the real discount rate of 8% is higher than the WACC, then the project is not
viable as it will not generate enough return to satisfy the providers of capital.
However, if the real discount rate is lower than the WACC, then the project is
viable as it will generate more return than the minimum required by the providers
of capital.

In this case, the real discount rate of 8% is higher than the WACC of 5.44%.
Therefore, the project is not viable as it will not generate enough return to satisfy
the providers of capital. S&Q should not proceed with the Project Trent as it will
not create value for the company's shareholders.

Furthermore, the real discount rate of 8% is higher than the UK government bond
yield of 0.8% for a 10-year maturity. This indicates that the real discount rate used
by S&Q is too high and not reflective of the risk associated with the project.
Therefore, S&Q should re-evaluate the real discount rate used for its projects and
adjust it to reflect the appropriate level of risk.

In conclusion, the appropriateness of S&Q choosing a real discount rate of 8% is

not suitable for the Project Trent as it is higher than the WACC and UK
government bond yield. S&Q should re-evaluate its real discount rate to ensure it
reflects the appropriate level of risk for its projects.
Q5. Calculate S&Q’s gearing ratio, and for the last year: Earnings Per
Share (EPS), Interest Cover, Dividend Cover and Total Shareholder
Return (TSR).

Answer:

To calculate the gearing ratio, we need to divide the total debt by the
total equity of the company:

Gearing Ratio = Total Debt / Total Equity

For S&Q, the total debt is £120 million and the total equity is £240
million, therefore:

Gearing Ratio = £120 million / £240 million = 0.5 or 50%

To calculate EPS, we need to divide the company's net profit by the

number of outstanding shares:

EPS = Net Profit / Number of Outstanding Shares

For the last year, S&Q's net profit was £50 million and the number of
outstanding shares was 100 million, therefore:
EPS = £50 million / 100 million = £0.50

To calculate the interest cover, we need to divide the company's

earnings before interest and taxes (EBIT) by the interest expense:

Interest Cover = EBIT / Interest Expense

For the last year, S&Q's EBIT was £100 million and the interest expense
was £20 million, therefore:

Interest Cover = £100 million / £20 million = 5

To calculate the dividend cover, we need to divide the company's

earnings per share by the dividend per share:

Dividend Cover = EPS / Dividend per Share

For the last year, S&Q's EPS was £0.50 and the dividend per share was
£0.20, therefore:

Dividend Cover = £0.50 / £0.20 = 2.5

To calculate the total shareholder return (TSR), we need to add the
change in share price to the dividends received and divide by the initial
share price:

TSR = (Ending Share Price - Beginning Share Price + Dividends) /

Beginning Share Price

For S&Q, the beginning share price was £2.00, the ending share price
was £2.50, and the company paid a dividend of £0.20 per share,
therefore:

TSR = (£2.50 - £2.00 + £0.20) / £2.00 = 0.35 or 35%

Q6. Analyze each of your calculations from Q5. What advice

would you give to a current investor?

Answer:

Gearing Ratio: The gearing ratio measures the proportion of a

company's debt relative to its equity. For S&Q, the gearing ratio is 0.5
or 50%, which indicates that the company has a relatively high level of
debt compared to its equity. While a high gearing ratio can provide
leverage for growth, it also increases the company's financial risk.
Therefore, investors should consider S&Q's debt levels carefully before
investing in the company.
EPS: EPS measures the amount of profit attributable to each
outstanding share of a company's stock. For S&Q, the EPS for the last
year was £0.50. A higher EPS is generally preferable for investors, as it
indicates that the company is generating more profit per share.
However, investors should also consider other factors, such as the
company's growth prospects and dividend policy, before making an
investment decision.

Interest Cover: Interest cover measures a company's ability to meet its

interest payments on outstanding debt. For S&Q, the interest cover for
the last year was 5, which indicates that the company is generating
sufficient earnings to cover its interest payments. This is a positive sign
for investors, as it suggests that S&Q is not at risk of defaulting on its
debt.

Dividend Cover: Dividend cover measures a company's ability to pay its

dividends to shareholders from its earnings. For S&Q, the dividend
cover for the last year was 2.5, which indicates that the company is
generating sufficient earnings to pay its dividends. However, investors
should also consider other factors, such as the company's dividend
history and growth prospects, before making an investment decision.

Total Shareholder Return (TSR): TSR measures the total return that an
investor has received from holding a company's stock, including capital
gains and dividends. For S&Q, the TSR for the last year was 35%, which
indicates that the company has performed well for investors. However,
investors should also consider other factors, such as the company's
future growth prospects and industry trends, before making an
investment decision.

In summary, based on our analysis of S&Q's financial ratios, investors

should carefully consider the company's debt levels, growth prospects,
dividend policy, and industry trends before making an investment
decision. While S&Q has performed well for investors in the last year, it
is important to consider both the company's past performance and its
future prospects before investing.

Q7. How should S&Q be funding its investments? Will the choice of
funding affect the cost of capital? Assess practical considerations and
relevant academic theories in reaching your conclusion.
Answer:
S&Q can fund its investments either through debt or equity financing.
Debt financing involves borrowing money, usually through issuing
bonds or taking out loans, while equity financing involves selling shares
of the company to investors.

The choice of funding will affect the cost of capital. Debt financing
generally has a lower cost of capital than equity financing because debt
providers expect to receive interest payments and the principal amount
back, while equity investors expect a return in the form of dividends or
capital appreciation. This means that using debt financing can lower the
overall cost of capital for S&Q.
However, there are practical considerations that need to be taken into
account when deciding on the optimal funding mix. For example,
excessive debt financing can increase the risk of bankruptcy,
particularly if interest rates rise or the company's earnings fall. On the
other hand, relying too heavily on equity financing can dilute existing
shareholders' ownership and control of the company.

From an academic perspective, the Modigliani-Miller (M&M) theorem

suggests that in a perfect market, the choice of funding should not
affect the cost of capital. However, in reality, markets are not perfect,
and the choice of funding can have real-world implications.

In conclusion, S&Q should aim for a balanced funding mix that takes
into account the company's risk profile, capital requirements, and
shareholder preferences. By striking a balance between debt and equity
financing, the company can optimize its cost of capital while minimizing
financial risk.