Page 18 - SCS May 2018 - Day 2 Suggested Solutions

CIMA MAY 2018 – STRATEGIC CASE STUDY

In this case it would seem sensible to base the ‘shorter’ period of time on the length of the
contracts for the new content, and as these are normally between 5 and 10 years a year-by-year
forecast over that period should be feasible. After this initial period we should then assume a
relatively low rate of growth, perhaps just reflecting the rate of inflation expected.

Discounting the cash flows

Once the incremental cash flows have been forecast, they then need to be discounted to their
present value, which requires the determination of a suitable discount rate.

Most business investment decisions are correctly assessed by discounting at the business’s
Weighted Average Cost of Capital (WACC), which is the weighted average cost of using equity and
debt finance. However, this is only valid if acceptance of the investment will not change the
existing WACC. In general, this will only be the case if two conditions are met:

1. The new investment has the same business risk as the company’s existing activities.
2. There is no change in the company’s gearing ratio as a result of the investment.

Having said that, if the investment is classed as ‘small’ (in comparison to the overall size of the
business) these conditions are often ignored on the basis that with a small investment the effect
of any change in business risk, and/or any change in the gearing, is likely to be insignificant and
will therefore not materially change the WACC.

Hence, whether we can use our existing WACC, without worrying about the two conditions above,
depends on the size of the investment required. If the investment is not “small” there are two
possible ways to proceed as considered below.

Business risk

This proposal represents an extension of our existing business and should, prima facie, therefore
have the same level of business risk as our existing activities. However, as you infer in your email,
the current political situation between Russia and the majority of the rest of the world makes this
highly questionable. It would seem necessary to allow for a higher level of business risk in the
proposed venture because of the potential political risk.

The starting point is to identify a quoted company which is already in the same line of business as
our proposed new venture (i.e. an company similar to ourselves operating in Russia) which would
give an indication of the level of risk involved in that business. The easiest way to do that is to
take the other companies β coefficient which measures the amount of systematic risk present.
Unfortunately the amount of systematic risk is affected by the level of gearing so we would need
to “un-gear” this β coefficient to get a measure of the systematic risk arising solely from the
nature of the business.

This is then “re-geared” using our own gearing level to measure the total amount of systematic
risk that our shareholders will experience from the new proposal. The resultant β coefficient is
then used in the Capital Asset Pricing Model (CAPM) to derive the rate of return our shareholders
should reasonably expect from the proposed new venture. Finally, this is then combined with our
existing cost of debt and gearing level to derive the risk adjusted WACC.

74 KAPLAN PUBLISHING