Exercise 1: Laptop PLC Is Planning To Set Up A Laptop Repair

Exercise 1laptop Plc Is Planning On Setting Up A Laptop Repair Centre

Exercise 1 Laptop plc. is planning on setting up a laptop repair centre. They estimate that: The required investment will be £0.3m and the investment’s life is expected to be 5 years. The investment is to be depreciated using the straight line depreciation method and none of the costs are expected to be recovered at the end of the 5 years. Total revenues from repairs are expected to be £200,000 in year one (one year from now), growing at 2.5% per annum. Staffing costs are £90,000 per year. Administrative, advertising, and general expenses associated with the centre are expected to be £20,000 per year. All costs are expected to increase at 2.5% per annum. The discount rate for ventures of similar risk is 12%. Laptop plc. faces a corporate tax rate of 35%.

a. Calculate the NPV of this project and determine whether it should be accepted or rejected.

b. Suppose you are told that Laptop plc. is totally equity financed. The company has a beta equal to 1.2. Appropriate estimates for the risk-free rate and the market risk premium are 2% and 4%, respectively. Calculate the NPV of this project and determine whether it should be accepted or rejected.

c. Suppose you are told that Laptop plc’s core business is not laptop repairs but production of laptop components. The beta of companies in the laptop repair business is generally around 2.5. Would you recommend accepting or rejecting the project? [Explain your answer in no more than 100 words]

d. In no more than 200 words, illustrate the concept of homemade leverage and explain the role it plays in Modigliani’s and Miller’s capital structure irrelevance result.

Paper For Above instruction

Setting up a new business venture requires meticulous financial analysis to determine its viability and strategic implications. Laptop plc.'s plan to establish a laptop repair center involves evaluating the project's net present value (NPV), considering various financial assumptions and market conditions. The initial investment of £300,000, spread over five years with straight-line depreciation, forms the basis for calculating cash flows. Revenue growth assumptions, cost escalations, tax rates, and discount rates are crucial parameters influencing the project's financial outcomes.

Calculating the NPV involves projecting future cash inflows from repairs, which start at £200,000 in the first year and grow at 2.5% annually. Corresponding costs, including staffing (£90,000 annually), administrative expenses (£20,000 annually), and inflation adjustments, are deducted from revenues to find operating cash flows. The straight-line depreciation of £60,000 per annum (i.e., £300,000 / 5 years) is added back to net income to obtain cash flows. The choice of discount rate at 12% reflects the risk profile of similar ventures, and after discounting these cash flows, the NPV computes to approximately -£3,841.78, indicating that the project may not be financially attractive.

In an alternative scenario, considering the company's total equity financing and beta of 1.2, the project’s risk profile changes. Using the Capital Asset Pricing Model (CAPM), the required rate of return adjusts to 6%, derived from the risk-free rate of 2% plus 1.2 times the market risk premium of 4%. The revised NPV calculation results in approximately £39,260.10, suggesting that, under these assumptions, the project becomes financially viable and should be considered for approval.

If the core business shifts from repairs to the production of laptop components, the risk profile notably changes. A beta of 2.5 indicates that the business is more sensitive to market fluctuations, implying higher risk and potentially higher expected returns. Given the increased risk, accepting the project would require a higher discount rate, which could diminish the project's net value. Hence, a careful risk assessment and strategic fit analysis are necessary before proceeding. Based on the increased beta, rejecting the project might be advisable unless the company can mitigate the higher risk.

Homemade leverage refers to the strategy where investors adjust their personal finance structure—either by borrowing or repaying debt—to alter the risk and return profile of their investment portfolios without changing the firm's original capital structure. This concept plays a vital role in Modigliani and Miller’s (1958) theorem, which states that in perfect markets, the firm’s value is unaffected by its capital structure, as investors can create leverage equivalent to the firm's structure personally. Therefore, capital structure irrelevance hinges on investors' ability to replicate leverage independently, emphasizing the inefficiencies of corporate leverage in theoretical models.

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