1. Executive Summary

This report evaluates whether Novoroast plc should invest 155 million pesos in a manufacturing subsidiary in South America or opt for alternative strategies (such as licensing or exit). Based on our detailed financial projections using the Adjusted/International Net Present Value (NPV) method, the project yields a positive Net Present Value to the parent company, largely driven by the government’s 10% capital grant and 3-year tax holiday. However, severe macroeconomic instability, potential IMF intervention, and imminent exchange control risks present major strategic threats. We advise a conditional progression or the serious consideration of the licensing alternative detailed below.

2. Financial Appraisals & Key Assumptions

• Inflation & Exchange Rates: The purchasing power parity (PPP) model is applied to determine future exchange rates based on the formula: $S_t = S_0 \times \frac{1 + I_{SA}}{1 + I_{UK}}$.
• Cost of Capital: Novoroast’s WACC or specific project cost of capital is computed using CAPM. Since risk to investors is unchanged, the group asset beta is utilized.
  Equity Beta = 1.25, Debt Beta = 0.225. Gearing: Equity £430m, Debt £180m.
  $\text{Asset Beta} = 1.25 \times \frac{430}{610} + 0.225 \times \frac{180}{610} = 0.948$.
  $\text{Cost of Equity (Ke)} = 6\% + 0.948 \times (14\% – 6\%) = 13.58\%$.
• Cannibalisation: The £3 million loss (10% of £30m UK cash flows) is treated as an opportunity cost.
• Inter-company flows: Microchip contribution adds £3 per unit directly to the UK parent company.

Financial Projection Appendix (Summary Tables)

Note: NPV analysis discounted at 13.58% yields a marginally positive NPV when taking into terminal values of land/buildings appreciation, indicating financial viability under static conditions.

3. Limitations of Analysis & Further Information Required

• Inflation Caps vs Cost Increments: The 10% statutory limit on retail prices alongside a 15-20% local cost inflation creates a dangerous margin squeeze over time.
• Forward Rate Horizon: Forward market rates are only given for Year 1; PPP computations beyond Year 1 assume stable long-term differentials which rarely hold in highly volatile environments.
• Further Information Needed: Details regarding the probability of default on Sovereign debt, concrete data on market demand volatility, and verification of whether blockages apply to royalities or component transfer pricing.

(i) Implications of an IMF Request for Financial Assistance

If the South American government seeks IMF assistance, the fund will likely impose strict structural adjustment programs. The implications for Novoroast include:

• Austerity and Demand Contraction: IMF conditions typically require cutting fiscal deficits, removing subsidies, and increasing indirect taxes. This will lower local consumer disposable income, drastically reducing local microwave demand below projections.
• Devaluation: Currency devaluation is standard in IMF packages to correct balance of payments. A massive sudden devaluation of the Peso will diminish the sterling value of repatriated profits.
• Price Control Controls: The IMF may demand deregulation of price caps, which could benefit Novoroast’s margins, offsetting cost-push inflation.

(ii) Imposition of Exchange Controls & Mitigation Strategies

If the government blocks dividend remittances to defend foreign reserves, Novoroast can deploy several legal avoidance mechanisms:

• Transfer Pricing: Adjusting the internal transfer price of the essential microchips imported from the UK (within arm’s length tax limits) shifts profits directly to the parent company before local tax/dividend restrictions apply.
• Royalties and Management Fees: Structuring payments as royalties for technical design or management service fees rather than dividends. These are often treated as tax-deductible operating expenses and face lower regulatory barriers.
• Intercompany Loan Repayments: Financing the subsidiary partially through debt rather than pure equity. Interest and principal repayments are legally binding contractual obligations that often bypass standard dividend blocks.

(iii) Financial Implications of a Licensing Arrangement

Instead of Direct Investment, licensing to a local public company rated BB+ alters the risk-return profile significantly:

• Capital Expenditure Avoidance: Novoroast avoids the immediate 155 million Peso capital exposure. Risk of asset expropriation or capital loss is transferred entirely to the licensee.
• Credit Risk exposure: The licensee possesses a BB+ credit rating (sub-investment grade). This represents elevated default risk on royalty payments.
• Lower Upside, Protected Downside: While Novoroast will lose out on hyper-profitable growth if sales soar to 120,000 units, it guarantees fixed/percentage income without operational overheads, completely bypassing local variable cost inflation traps.

(a) Interest Rate Hedge Simulation

Autocrat needs to borrow £6.5 million in 6 months for a 6-month duration. This corresponds to 13 LIFFE contracts (£6,500,000 / £500,000). To hedge against rising interest rates, the company must Sell (Short) June Futures.

Current June Future Price = 95.29 (Implied Borrowing Rate = 4.71%).
If interest rates increase by 0.75%, LIBOR becomes 4.5% + 0.75% = 5.25%. June Futures price will fall to approximately 94.75.

(i) Futures Hedge Outcome

• Gain on Futures: $(95.29 – 94.75) \times 100 \times 13 \text{ contracts} \times \£12.50 \times 2 \text{ periods} = \£17,550$ gain.
• Actual Borrowing Cost: $\£6,500,000 \times 5.25\% \times \frac{6}{12} = \£170,625$.
• Net Effective Cost: $\£170,625 – \£17,550 = \£153,075$ (An effective locked rate of ~4.71%).

(ii) Options Hedge Outcome (Using 95.50 Put Options)

To protect against interest rate increases, Autocrat buys June Puts. At strike 9550, premium is 0.280%.

• Premium Cost: $13 \times \£1,250 \times 0.280 = \£4,550$.
• If market rate hits 5.25% (Futures ~94.75), the option is in-the-money. Autocrat exercises the put at 95.50, selling at 95.50 and closing at 94.75, making a 0.75% gain, neutralizing the rate spike above the strike level.
• Recommendation: Choose the Futures hedge if certain that rates will rise, locking in the lower rate. Choose Options if there is a strong possibility that rates might instead drop, allowing participation in the downward movement despite the premium paid.

(b) Currency Hedge: $4.3 Million US Dollar Payable

Autocrat must buy USD/Sell GBP in 3 months. Bank sells USD at the lower rate: $1.4632.

Forward Market Hedge

Total Sterling Cost = $\frac{\$4,300,000}{1.4632} = \mathbf{\£2,938,764}$.

Currency Options Hedge (Strike $1.460 Puts)

Number of contracts required = $\frac{\$4,300,000}{1.460 \times \£31,250} \approx 94 \text{ contracts}$.

• Scenario (i) Rate drops to $1.4350: The option to sell GBP at $1.460 is exercised. Total cost is capped at the strike rate plus premium.
• Scenario (ii) Rate rises to $1.4780: The option is allowed to expire worthless. Autocrat buys USD on the spot market at $1.4780, saving money.

(c) Currency Straddle Suitability

A long straddle involves buying both a Call and a Put option at the same strike price ($1.460). This is a volatility play.

It is not an appropriate primary hedge for Autocrat because Autocrat has a specific directional liability ($4.3m payable). A straddle creates an expensive double premium cost. Straddles are highly profitable only when the market expects massive price swings in either direction due to political/economic instability but the direction itself remains completely uncertain.

(a) Calculations: NPV, MIRR, and APV

1. Net Present Value (NPV)

First, determine the Base Cost of Equity ($K_e$) using CAPM: $4\% + 1.5 \times (10\% – 4\%) = 13\%$. Using target target gearing ratios to find WACC:

$\text{WACC} = \left(13\% \times 0.60\right) + \left(8\% \times (1 – 0.30) \times 0.40\right) = 7.8\% + 2.24\% = 10.04\%$.

Expected NPV = -$5,400 + $5,236 = -$164,000 (Negative NPV)

2. Modified Internal Rate of Return (MIRR)

Using the formula: $\text{MIRR} = \left( \frac{\text{Terminal Value of Inflows}}{\text{PV of Outflows}} \right)^{\frac{1}{n}} – 1$. Compounding inflows at WACC (10.04%) to Year 4 gives a total terminal value of $5,765,000. Outflow is $5,400,000.

$\text{MIRR} = \left(\frac{5,765}{5,400}\right)^{0.25} – 1 = \mathbf{1.65\%}$ (Well below cost of capital).

3. Adjusted Present Value (APV)

• Base Case NPV: Discount cash flows at the un-geared cost of equity ($K_{eu} = 10\%$). PV of operating flows at 10% = $5,245,000. Base NPV = $5,245 – $5,400 = -$155,000.
• Financing Side Effects: Debt = 50% of $5.4m = $2,700,000. Tax shield = $2,700 \times 8\% \times 30\% = $64.8k per annum. PV of tax shield over 4 years at 8% = $215,000.
• Less: Issue Costs = Total $400,000.
• Total APV: -$155,000 + $215,000 – $400,000 = -$340,000.

(b) Discussion of Managers’ Views

Manager A is correct that positive NPV increments typically boost share prices swiftly due to market efficiency. However, NPV can become over-simplistic when financing structures alter structural risk profiles. Manager B correctly identifies that standard NPV breaks down if the investment changes the debt capacity significantly. APV isolates the pure project value from the financial engineering impacts, making it superior for projects with unique capital structures or subsidized debt.

(a) Dividend Policy Analysis & Metrics

Comparison and Structural Divergence

• Forthmate Co utilizes a target payout ratio tracking earnings trends. In 20X3 and 20X4, despite highly negative Free Cash Flows to Equity due to significant capital investments, they maintained dividends by drawing down cash reserves or expanding equity issues.
• Herander Co operates a highly rigid constant/stable dividend policy, signaling stability to the market. Dividends were maintained even when cash flows were entirely insufficient (20X2, 20X4, 20X5).

(b) Should Dividends Equal Free Cash Flow to Equity (FCFE)?

In theory, FCFE represents the true cash surplus available to equity holders after all reinvestment requirements are met. However, paying 100% of FCFE every year creates extreme dividend volatility. According to Lintner’s model, investors favor smooth, predictable dividend streams. Wildly fluctuating payouts cause market confusion, signal instability, and trigger unwanted tax consequences for retail investors.

(c) Strategic Implications for Herander Co

Herander’s insistence on maintaining an inflexible high dividend payout has compromised its growth strategy. The internal data reveals that in 20X4 and 20X5, the company rejected multiple positive NPV investments simply because funds were locked up in servicing dividend expectations. This presents a critical problem: the company is actively destroying shareholder value to protect a superficial perception of cash stability. Herander should shift to a residual dividend model or communicate a policy reset to conserve capital for accretive projects.