Mid Term Paper

1.
Koriak Company is a small software design business established four years ago. The
company is owned by three directors who have relied upon external accounting services
in the past. The company has grown quickly and the directors have appointed you as a
financial consultant to advice on the value of the business under their ownership.
The directors have limited liability and the bank loan is secured against the general assets
of the business. The directors have no outstanding guarantees on the company’s debt.
The company’s latest income statement and the extracted balances from the latest
statement of financial position are as follows:
Income Statement ’000 Financial Position 000

Revenue 5,000 Opening non-current assets 1,200
Cost of Sales 3,000 Additions 66
–––––– ––––––
Gross profit 2,000 Non-current assets (gross) 1,266
Other operating costs 1,877 Accumulated depreciation 367
–––––– ––––––
Operating profit 123 Net book value 899
Interest on loan 74 Net current assets 270
––––––
Profit before tax 49 Loan (990)
––––––
Income tax expense 15 Net Assets Employed 179
–––––– ––––––
Profit for the period 34
––––––
During the current year:
(1) Depreciation is charged at 10% per annum on the year end non-current asset balance
before accumulated depreciation, and is included in other operating costs in the income
statement.
(2) The investment in net working capital is expected to increase in line with the growth
in gross profit.
(3) Other operating costs consisted of:
‘000
Variable component at 15% of sales 750
Fixed costs 1,000
Depreciation on non-current assets 127
(4) Revenue and variable costs are projected to grow at 9% per annum and fixed costs are
projected to grow at 6% per annum.
(5) The company pays interest on its outstanding loan of 7·5% per annum and incurs tax
on its profits at 30%. The company does not pay dividends.
(6) The net current assets reported in the statement of financial position contain Rs
50,000 of cash.
One of your first tasks is to prepare for the directors a forward cash flow projection for
three years and to value the firm on the basis of its expected free cash flow to equity. In
discussion with them you note the following:
– The company will not dispose of any of its non-current assets but will increase its
investment in new non-current assets by 20% per annum. The company’s depreciation
policy matches the currently available tax write off for capital allowances. This straight-
line write off policy is not likely to change.
– The directors will not take a dividend for the next three years but will then review the
position taking into account the company’s sustainable cash flow at that time.
– The level of the loan will be maintained at Rs 990,000 and, on the basis of the forward
yield curve, interest rates are not expected to change.
– The directors have set a target rate of return on their equity of 10% per annum which
they believe fairly represents the opportunity cost of their invested funds.
Required:
(a) Prepare a three-year cash flow forecast for the business on the basis described above
highlighting the free cash flow to equity in each year.
(b) Estimate the value of the business based upon the expected free cash flow to equity
and a terminal value based upon a sustainable growth rate of 3% per annum thereafter.
Note: PV factors @10%

1 2 3 4 5
0.909 0.826 0.751 0.683 0.621
2.
The Gray Ltd. earned Rs 3.50 per share last year. Investment in fixed assets was Rs 2.00
per share, depreciation was Rs 1.60, and the investment in working capital was Rs 0.50
per share. Gray is currently operating at its target debt-to-asset ratio of 40%. Thus, 40%
of annual investments in working capital and fixed assets will be financed with new
borrowings. If shareholders require a return of 14% on their investment, and the expected
growth rate is 4%, then what is the fair value of Gray's stock

Mid Term Paper

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1.

Income Statement ’000 Financial Position 000

Note: PV factors @10%

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