Question 1
Network Streaming Systems (NSS) Ltd is a video production company and currently rents the building in which its production equipment is located at an annual cost of El 50,000, including all service charges.
The company is considering purchasing an alternative building in which to undertake its video business. These alternative premises are due to be demolished by the local council in 4 years' time to make way for a new road. It is known that the Council will purchase the building at that time at its book value of E100,000. Because of the instability caused by the Council's plans, NSS can purchase the building at a knock-down price of €250,000. Otherwise, since the building is located in a prime residential area, the land on which the building stands would be worth El .8 million. Currently the building is in a state of disrepair, but a structural survey which has already been undertaken by NSS costing E3,OOO, recommends that the building must be upgraded at a cost of E50,OOO before NSS moves in.
The annual heating and lighting expenses on the new building will be €40,000, but NSS will save the annual rents on its current premises. The removal costs of moving its equipment into the new building, and the cost of moving out again in four years' time will be E25,000 on each occasion.
NSS pays corporation tax on its profits at 30%, and the tax authorities allow NSS to offset its corporate tax liabilities by using straight line depreciation on its fixed assets. You may assume that NSS has sufficient taxable profits to take full advantage of any tax shields from purchasing the building. NSS applies an opportunity cost of capital of 10 per cent to all future cash flows. Assume all annual cashflows occur at the end of the year to which they relate.
(a) Determine the free cash flow in each year from the investment in the new building, explaining your treatment of costs and depreciation allowances. (10 marks)
(b) What is the project NPV? (2 marks)
(c) NSS approaches you for advice on whether it should purchase the new building, and asks for your opinion on payback, IRR, and accounting rate of return as methods of investment appraisal. Advise NSS by comparing and contrasting the four alternative investment criteria. (8 marks)
(d) Suppose that there is a small probability that the Council might change its decision to build a road, allowing the owner to sell the land for residential development. Outline how this would change your valuation of the project. (5 marks)
Question 2
Tinpot Resources (TR), an all-equity firm, is considering purchasing the rights to operate an iron ore mine in the Pilbara region of Western Australia. Acquiring the rights will cost $50,000 today (time O) but will also oblige TR to pay substantial environmental rehabilitation costs of $250,000 when the mine is shut down in 3 years' time. While in operation, the mine is expected to produce 20,000 tonnes of iron ore per year, with extraction costs running at $93 per tonne. 3/10 Although TR knows it can sell iron ore in the market for $100 per tonne year, it faces considerable uncertainty regarding the future iron ore price, which is equally likely to rise by 10% or fall by 15% in each of the subsequent two years. There are no taxes or any other costs. Unless otherwise stated, assume any cash flows occur at the end of each year. Use a discount rate of 20% for all cash flows. Show your calculations.
a) Draw a binomial tree depicting the possible market prices of iron ore during the mine's operating life. Remember, the price in year 1 is known with certainty. What is the expected market price of iron ore in years 2 and 3? (4 marks)
b) Calculate the NPV of the project. Should TR purchase the rights? (6 marks)
c) Explain why using the IRR rule is likely to result in an incorrect decision when evaluating this project (do not attempt to calculate the IRR). Be specific. (4 marks) Now assume that TR has the ability to temporarily halt extraction operations if iron ore prices move adversely. However, by doing so, it cannot avoid paying the environmental rehabilitation costs at the end of the mine's life.
d) When will TR choose to exercise this option? Explain fully. (4 marks) e) Determine the value of the abandonment option and comment on the source of the option value. (7 marks)
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