BUSF_A01.qxd

(Darren Dugan) #1
Suggested answers to selected problem questions

Tax on incremental cash flows
Total incremental cost (excluding depreciation) =£4.172m +£4.338m =£8.510m

-^13 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:
lThe small margin of safety means that the success of the contract will be sensitive to
the accuracy of the input data.
lCivil engineering tends to be a fairly risky activity since outcomes are difficult to
predict.
lIn the long run, the contract price must bear head office costs.
lPrecedent for future contracts.

BUSF_Z03.qxd 11/19/08 10:33 Page 483

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