It is the year 2012. The Chief Executive of XYZ Systems Plc, a growing firm in the telecommunication sector, has called your team for an important meeting. "We are expanding": he said, "In the last meeting of the board of directors, we have come to a decision that we should expand our firm by providing new services including cable TV, fibre optics internet technology and a landline telephone network. I want your team to make this task your priority now."
"This new project will be totally financed by equity. Our shareholders are demanding a full analysis of our operating, financing and dividend distribution decisions over the last 4 years. Could you and your team study this and make a report to our Board, critically analysing and commenting upon the financial performance, policies and strategies? If you think there are any areas of weakness, I shall expect clear reasoning and explanations, and even suggestions for alterations -Your suggestions should reflect the fact that we will need a substantial funding for our new project." "Oh, before you're dismissed. This is an extract from the Chairman's circular to the shareholders. You will need that for your analysis. I'd also like you to do an investment appraisal of the proposed project on the basis of the information contained in the circular."
Extracts from the Chairman's circular to the shareholders XYZ Systems plc are enclosed, along with the company's summarised financial statements for the last four years and competitors' information. As the fund management team of XYZ Systems plc, prepare and submit the written report required by the Chief Executive. The report should consist of two parts:
The first part requires analysing the performance of the financial position of the company based on past information (trend analysis and cross-sectional analysis) and making relevant recommendations.
The second part entails forecasting future cash flows and implementing capital budgeting methods to evaluate the proposed investment. Excel spreadsheets are required along with the report.
A critical evaluation of the chairman's circular based on your analysis is required for parts 1 and 2.
XYZ SYSTEMS PLC
EXTRACTS FROM THE CHAIRMAN'S CIRCULAR
The performance and financial position of our group show a picture of great strength. The last four years have seen our company's operations become increasingly diversified, and our turnover has increased by more than 40% over the last four years - a clear indication of successful management. Our share price has gone up monotonically over the same period. And since the end of the last financial year, we have drawn up plans for extending our range of services. We plan to offer international TV channels from all over the globe to capture the market of non-native residents in the country. We also intend to provide cheap international calls through our newly proposed landline network. The sales from the new project will certainly result in a substantial increase in shareholder value, further boosting the company's share price. It will be one more step towards the achievement of our corporate objective of becoming a major provider of cable TV and internet services when these are now provided by only two major competitors in the media and entertainment sector. A clear need for such an investment has been established by our comprehensive market research survey, which has just been completed at a cost of £50,000.
The impact of this project on our existing products has also been studied. Since we are currently a mobile telephone network provider, our new fixed line network is expected to have an adverse impact on our existing sales which is estimated to be not more than £2 million a year, a The capital cost of setting up the fibre optics internet, cable TV services and the aerial sites would be £50 million, an expenditure that would attract capital allowances on a straight-line basis over 10 years, commencing from the first year of operation. The capital expenditure will happen one year before operations start. Of course, since depreciation is not really a cash flow, this is not relevant for appraisal of the project. However, our current 30,000 sq. ft. headquarters office in Gloucestershire can accommodate the required customer service offices for the new departments, which is assumed to make use of only 50% of the total space. The annual mortgage costs for the factory building is approximately £80,000. Working capital of £1½ million will need to be invested before commencing operations, and it is expected that the same level of working capital would be sufficient for the duration of the project. The proposed services that will be offered include fibre optics internet, cable TV and a landline telephone network. The total costs associated with the research implemented for development of these new technologies were £1,000,000 paid before the setting up process. Our sales forecasts suggest that: Landline subscribers are going to be 10,000 in the first year and would double over the following four years. Thereafter, the number of customers is going to remain constant for the rest of the project's life. The number of internet subscribers is expected to be 30,000 in each year.
Cable TV subscribers are expected to be 20,000 over the first five years of the project and would increase to 40,000 subscribers in year 6 where they would remain constant for the rest of the project's life. The number of the bundle subscribers is expected to be 10,000 in the first year and would increase by 10,000 each year until the tenth year when it would settle unchanged for the remaining life of the project. The project does not have a limited lifetime, and although technology would develop in the future that would affect our type of services provided, we assume that our sales and market share are going to remain unaffected. Our marketing department have estimated the average prices of our range of services as follows: the annual landline subscription is going to be £240; the internet subscription is going to be £180 per year; the annual TV cable subscription is £240; and the finally the annual subscription of the bundle product is averaged at £400. The prices will be expected to rise every year according to inflation levels.
The main operating cost would be the annual staff costs, which is expected to be 30% of the same year's revenue, while the maintenance and inventory costs are forecasted at 10% of the revenue. Other significant operating costs would be services such as gas, electricity water, and other miscellaneous costs amounting to £1 million per year. All the above revenues, costs and values are estimated at current prices before the implementation of the project, and take no account of inflation. The current level of inflation is 3% per year, and is expected to continue at this level for the foreseeable future, therefore a careful appraisal of this project necessitates adjusting both revenues as well as costs for inflation. Based on current market rates of return, the after tax weighted average cost of capital for firms within the same industry is 18% (nominal or money interest rate). This rate would represent the opportunity cost of capital to fund the new project. The company will continue to pay corporation tax at the rate of 30 percent per annum for the foreseeable future. We are conservatively assuming that this project will not have a termination date. Although the equipment installed in year zero are to be depreciated over the next 10 years, we do not require any further investment.