Past Papers - Examiner's Solutions December 2008 Question 1 The Crammond Manufacturing Plc has a number of factories around the country and it needs to upgrade the water purification systems in its factories. The company is looking at two possible systems: the first, the Titan, will cost £120 000 per installation and will have an operating cost of £11 000 annually; the other system, the Colossus, will cost £225 000 per installation and has an annual operating cost of £6000 per installation. Both systems will be depreciated straight line to zero over their working lives. The Titan will be replaced every 5 years and the Colossus will be replaced every 8 years. The company faces a tax rate of 30%. This is a normal project for the company, which has an asset beta of 0.9 and an equity beta of 1.0875. The company is 80% funded by equity and has just paid an annual dividend of 23.4p and its share price is 260p. The risk free rate of interest is 4.35% and the stock market risk premium is 5.5%. Ignore inflation. Required: a. Calculate the cost of capital that would be used to evaluate this investment decision. (5 marks) b. Work out the equivalent annual cost for each machine and explain which system you would choose. (7 marks) c. Book values or market values? Indicate which one is used in calculating the WACC and why it is that one and not the other one. (4 marks) d. Describe the impact that inflation has on depreciation, salvage values, and their tax in capital budgeting. (6 marks) e. Explain what the main differences are between accounting figures and cash flows for use in capital budgeting. Describe how you would obtain a figure for free cash flows (FCF*) from an income statement and balance sheet. (8 marks) Case Solution 1 (a) Calculate the cost of capital that would be used to evaluate this investment decision. (5 marks) Cost of capital Equity Debt Asset beta rf Finance Edinburgh Business School Beta Weight 1.0875 0.8 0.15 0.2 0.9 Asset beta – Equity weighted beta