Professional Level – Skills Module, Paper P4 Advanced Financial Management 1
December 2011 Answers
Up to 4 professional marks are available for the presentation of the answer, which should be in a report style. (i) Initial Evaluation The information provided has been used to assess whether the production of the X-IT should be moved to Gamala from the USA. Initially a base case net present value calculation is conducted to assess the impact of the production in Gamala. This is then adjusted to show the impact of cash flows in the USA as a result of the move, the immediate impact of ceasing production and the impact of the subsidy and the tax shield benefits from the loan borrowing. The calculations presented in the appendix show that the move will result in a positive adjusted present value of just over $2·4 million. On this basis, the production of X-IT should cease in the USA and the production moved to Gamala instead. Assumptions It is assumed that the borrowing rate of 5% is used to calculate the benefits from the tax shield. It could be argued that the risk free rate of 3% could be used as the discount rate instead of 5% to calculate the present value of benefits from the tax shields and the subsidies. In adjusted present value calculations, the tax shield benefit is normally related to the debt capacity of the investment, not the actual amount of debt finance used. Since this is not given, it is assumed that the increase in debt capacity is equal to the debt finance used. It has been assumed that many of the input variables, such as for example the tax and capital allowances rates, the various costs and prices, units produced and sold, the rate of inflation and the prediction of future exchange rates based on the purchasing power parity, are accurate and will change as stated over the four-year period of the project. In reality any of these estimates could be subject to change to a greater or lesser degree and it would be appropriate for Tramont Co to conduct uncertainty assessments like sensitivity analysis to assess the impact of the changes to the initial predictions. (Note: credit will be given for alternative relevant assumptions) (ii) Government Change From the preamble it would seem that a change of government could have a significant impact on whether or not the project is beneficial to Tramont Co. The threat to raise taxes may not be too significant as the tax rates would need to increase to more than 30% before Tramont Co would lose money. However, the threat by the opposition party to review ‘commercial benefits’ may be more significant. Just over 40% of the present value comes from the tax shield and subsidy benefits. If these were reneged then Tramont Co would lose a significant amount of the value attached to the project. Also the new government may not allow remittances every year, as is assumed in part (i). However, this may not be significant since the largest present value amount comes from the final year of operation. Other Business Factors Tramont Co should consider the possibility of becoming established in Gamala, and this may lead to follow-on projects. The real options linked to this should be included in the analysis. Tramont Co’s overall corporate strategy should be considered. Does the project fit within this strategy? Even if the decision is made to close the operation in the USA, there may be other alternatives and these need to be assessed. The amount of experience Tramont Co has in international ventures needs to be considered. For example, will it be able to match its systems to the Gamalan culture? It will need to develop strategies to deal with cultural differences. This may include additional costs such as training which may not have been taken into account. Tramont Co needs to consider if the project can be delayed at all. From part (i), it can be seen that a large proportion of the opportunity cost relates to lost contribution in years 1 and 2. A delay in the
