Reference no: EM131565203

Question 1

Rainbow Energy Solutions plc has spent £12m designing and developing a new generation of domestic air source heat pumps. These new domestic heat pumps can easily be fitted to existing wet heating systems and will reduce both household heating bills and greenhouse gas emissions significantly. This is Rainbow's first venture into the domestic market. Rainbow will continue to manufacture and sell their larger commercial models of air and ground source heat pumps. This new generation of domestic air source heat pumps is expected to have a production life of five years.

Rainbow already owns a suitable empty building on a site adjacent to their existing factory. Currently the land and buildings are recorded in the financial accounts at a historically depreciated cost of £500k. A recent survey suggests the open market value of this land and building is around £8m. The new production line would be built in this building. Initial investment in plant and equipment will be £60m. Rainbow charges depreciation on a straight line basis over the useful life of non-current assets. The project will also require additional working capital investment of £10m for the life of the project. It is expected that only 80% of the working capital investment will be recovered at the end of the project.

Currently, investment in plant and equipment is eligible for capital allowance on a straight line basis over four years. The applicable corporation tax rate is 22%. Capital allowances are received in the same year they are claimed. However, corporation tax on profits is paid one year in arrears.

Rainbow expects to sell 10,000 pumps in the first year at a price of £3,000. Thereafter sales volumes are expected to grow to 16,000 pumps for each of the next four years. Rainbow will incur additional annual administration costs of £4m. Total incremental operating costs to produce the pumps will be £12m in the first year of operation and £16m per annum thereafter. All cash flows are in nominal terms - inflation is expected to be negligible over the next five years.

By delaying the project by 12 months, however, sales volume in the first year of production would be expected to be 16,000 pumps but incremental operating costs would be £16m. Sales volume and incremental operating costs would therefore be the same in each year of the project.

Rainbow's shares currently trade at £4.95 each with an equitybetaof 1.6. Dividend payments have increased steadily over the past four years. The expected equity risk premium is 7% and the risk free rate is 3%. Rainbow currently has a market value gearing ratio [debt / (debt + equity)] of 30%. Rainbow has sufficient resources available to fund this new project from existing facilities. The current average cost of borrowing before tax for the company is 4%.

a. Estimate the weighted average cost of capital (WACC) for Rainbow.

b. Carry out a discounted cash flow (DCF) investment appraisal of the project based on the information given for an immediate start. Calculate the net present value (NPV) and internal rate of return (IRR). Discuss and justify your chosen discount rate. If the discount rate you use in your DCF analysis differs from the WACC estimated in part (i), explain why.

c. Calculate the net present value (NPV) and internal rate of return (IRR) of the project starting in 12 months' time.

d. Give a clear recommendation whether the project should be started now or in 12 months' time. Explain and justify your recommendation.

Question 2

find the excel file: US Stock Markets attached. This file contains annual data for the US S&P stock price index, namely: annual prices, dividends and earnings, all starting in 1871.

a. Use the Gordon growth model, as defined in Unit 2, to estimate the long-term equity return over the period from 1926 to 2015 (note: you will only need the initial dividend yield and the constant annual growth rate of dividends).

b. Over shorter periods, it is usually assumed that a third factor is also critical in determining returns. This factor is related to the change in valuation relationships, and it is captured by the constant annual growth of the price-to-earnings ratio. On the basis of this assumption, calculate the average equity return for the following sub-periods: 1947-1968, 1969-1981, and 1982-2000. Show your calculations.

c. Compare the calculated stock returns in the above sub-periods. Is the change in valuation an important factor and how does it influence the results? Explain your argument.

Attachment:- Stock Markets material.xlsx