The Independent Film Company plc is a film distribution company which purchases distribution rights
on films from small independent producers, and sells the films on to cinema chains for national and
international screening. In recent years the company has found it difficult to source sufficient films to
maintain profitability. In response to the problem, the Independent Film Company has decided to
invest in commissioning and producing films in its own right. In order to gain the expertise for
this venture, the Independent Film Company is considering purchasing an existing filmmaking
concern, at a cost of £400,000.
The main difficulty that is anticipated for the business is the increasing uncertainty as to the potential
success/failure rate of independently produced films. Many cinema chains are adopting a policy of
only buying films from large international film companies, as they believe that the market for
Independent films is very limited and specialist in nature. The Independent Film Company is
prepared for the fact that they are likely to have more films that fail than that succeed, but believe
that the proposed film production business will nonetheless be profitable.
Using data collected from the existing distribution business and discussions with industry experts,
they have produced cost and revenue forecasts for the five years of operation of the proposed
investment. The company aims to complete the production of three films per year. The after tax cost
of capital for the company is estimated to be 14%.
Year 1 sales for the new business are uncertain, but expected to be in the range of £4–10 million.
Sales (£mil)
4
5
7
10
Prob
0.2
0.4
0.3
0.1
Probability estimates for different forecast values are as follows:
Sales are expected to grow at an annual rate of 5%.
Anticipated costs related to the new business are as follows:
Cost Type
£’000
Purchase of film-making company
Annual legal and professional costs
Annual lease rental (office equipment)
Studio and set hire (per film)
Camera/specialist equipment hire (per film)
Technical staff wages (per film)
Screenplay (per film)
Actors’ salaries (per film)
Costumes and wardrobe hire (per film)
Set design and painting (per film)
Annual non-production staff wages
400
20
12
180
40
520
50
700
60
150
60
Additional Information
(i) No capital allowances are available.
(ii) Tax is payable one year in arrears, at a rate of 33% and full use can be made of tax refunds as
they fall due.
(iii) Staff wages (technical and non-production staff) and actors’ salaries, are expected to rise by 10%
per annum.
(iv) Studio hire costs will be subject to an increase of 30% in Year 3.
(v) Screenplay costs per film are expected to rise by 15% per annum due to a shortage of skilled
writers.
(vi) The new business will occupy office accommodation which has to date been let out for an annual
rent of £20,000.
Demand for such accommodation is buoyant and the company anticipates no problems in finding
future tenants at the
same annual rent.
(vii) A market research survey into the potential for the film production business cost £25,000.
Required:
(a) Using DCF analysis, calculate the expected Net Present Value of the proposed investment.
(Workings should be rounded to the nearest £’000.) (15 marks)
(b) Outline the main limitations of using expected values when making investment decisions.
(6 marks)
(c) In addition to the possible purchase of the film-making business, the company has two other
investment opportunities, the details of which are given below:
Post-Tax Cash Flows, £’000
Year 0
Year 1
Investment X (200)
200
Investment Y (100)
80
Year 2
200
80
Year 3
150
40
Year 4
100
40
Year 5
100
40
Year 6
100
40
The Independent Film Company has a total of £400,000 available for capital investment in the
current year. No project can be invested in more than once.
Required:
(i) Define the term profitability index, and briefly explain how it may be used when a company
faces a problem of capital rationing in any single accounting period. (4 marks)
(ii) Calculate the profitability index for each of the investment projects available to the
Independent Film Company, i.e. purchase of the film production company, Investment X and
Investment Y, and outline the optimal investment strategy. Assume that all of the projects are
indivisible. (6 marks)
(iii) Explain the limitations of using a profitability index in a situation where there is capital
rationing. (4 marks)
(d) Briefly explain how the tax treatment of capital purchases can affect an investment
decision. (5 marks)
(40 marks)