Business finance : theory and practice

Suggested answers to selected problem questions
Tax on incremental cash flows
Total incremental cost (excluding depreciation) = £4.172m + £4.338m = £8.510m
1– 3
thereof = £2.837m
Tax charge (£4.500m − £2.837m) @ 30% = £0.499m
‘Money’ discount rate
20X6 = 1/(1.00 + 0.10) × (1.00 + 0.03) = 0.8826
20X7 = 0.8826 × 1/(1.00 + 0.10) × (1.00 + 0.04) = 0.7715
20X8 = 0.7715 × 1/(1.00 + 0.10) × (1.00 + 0.05) = 0.6680
Schedule of ‘money’ cash flows
31 December 20X5 20X6 20X7 20X8
£m £m £m £m
Contract price – 4.500 4.500 4.500
Incremental cost – (4.172) (4.338) –
Plant (2.500) – – –
Addition (0.100) – – –
Capital allowances (0.600) – – –
0.345 0.259 0.776 –
Tax – (0.499) (0.499) (0.499)
(2.855) 0.088 0.439 4.001
PV (2.855) 0.078 0.339 2.673
NPV 0.235
Thus the contract would be financially advantageous to BC at £13.5m.
(b) If the contract price were £12m, the differential ‘money’ cash flows would be as follows:
31 December 20X5 20X6 20X7 20X8
£m £m £m
Lower contract receipts – (0.500) (0.500) (0.500)
Lower tax charge – 0.150 0.150 0.150
(0.350) (0.350) (0.350)
PV (0.309) (0.270) (0.234)
NPV (0.813)
NPV at a contract price of £12.0m = 0.235 − 0.813 = (0.578)
‘Break-even’ contract price = £13.5m − {(13.5m − 2.0m) × [0.578/(0.235 + 0.578)]}
= £12.434m or 3 instalments of £4.145m each
(c) Possible ‘other factors’ include:
l
l
l
l
The small margin of safety means that the success of the contract will be sensitive to
the accuracy of the input data.
Civil engineering tends to be a fairly risky activity since outcomes are difficult to
predict.
In the long run, the contract price must bear head office costs.
Precedent for future contracts.
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