Reference no: EM132134677

The objective of this assignment is to encourage students to use Excel spread sheets to aid in solving a capital budgeting problem, and to analyse how the market impounds new information into stock prices.

Hypothetical company background

Tastegood Limited is a public listed company that specializes in the production of confectionery. The production relies heavily on the use of machinery. The company has 215,000 number of shares outstanding trading on the stock exchange.

Part 1

Tastegood is currently in negotiation with a large supermarket chain, Cheap & Good Limited, to supply its confectionery in a private label for Cheap & Good. Under the terms, Tastegood is expected to supply confectionery to Cheap & Good every year for the next ten years.

If Tastegood proceeds with the supply of confectionery, the company needs to purchase ma- chinery to cope with the increase in production. New machinery is expected to cost $2,600,000, with an additional $200,000 installation and shipping costs. The machinery is expected to have a working life of 10 years. The company's accounting policy is to depreciate using the reducing balance approach. For the new machinery, the company decides to use a depreciation rate of 20% per annum. It is expected that the new machinery can be sold for $200,000 at the end of its useful life.

If Tastegood is to proceed with the supply of confectionery to Cheap & Good, it is expected that the yearly operating revenues would increase by $800,000 in year one. From year two onwards, it is expected that the increase in yearly operating revenues would grow at a rate of 10% per annum. Total variable and fixed operating costs associated with increased production would be 40% of the increase in yearly operating revenues. However, as the private label confectionery's selling price is cheaper than Tastegood's brand, it is expected that Tastegood's existing operating revenues would fall by $200,000 per annum and existing operating costs would decrease by $80,000 per annum if Tastegood proceeds with the supply of confectionery. Moreover, there would be an initial increase in net working capital of $50,000. From year one to year nine, net working capital is expected to increase by $10,000 per year. All the net working capital can be recovered at the end of the project's life.

The company requires you to calculate an appropriate discount rate using the company's weighted average cost of capital. The company's capital structure has remained fairly stable, with a debt-to-equity ratio of 0.8. The company has no plan to adjust its capital structure in the future. Given that the company is listed on the stock exchange, you are able to obtain the historical returns over the last 20 years for the company, the market portfolio and the risk-free asset as tabulated in Table 1. The company debentures have a face value of $1000 and a coupon rate of 12%. They mature in 5 years time. Similar debentures are currently yielding 15%. The company tax rate is 30%.

Table 1 Historical yearly returns for Tastegood, market and risk-free bond

Furthermore, the CEO suggests conducting sensitivity analysis as follows because of uncer- tainty in relation to some of the expected cash flows:

1. Allow for a 30% probability that incremental revenues associated with the supply of private label confectionery would be 40% lower than expected starting from year six;

2. Allow for a 20% probability that incremental revenues associated with the supply of private label confectionery would be 20% higher than expected starting from year six.

Part 2

Semi-strong form efficiency tests are concerned with whether security prices reflect all publicly available information. The event study methodology can be used to investigate the effects of many events such as a corporate announcement. By studying the stock price reaction before, during and after an announcement, an examination of whether the market is semi-strong form efficient can be conducted.
After performing the full analysis in Part 1, assume that Tastegood decides to proceed with the supply of private label confectionery to Cheap & Good. As such, the company announces details related to the expected increase in profits and cash flows that it would achieve from the supply of private label confectionery. The table below shows the daily returns of Tastegood (stock), the market and the risk-free asset 5 days before and after the announcement. Day 0 is the day of the announcement and there is no other price-sensitive announcement within the event window.

Table 2 Daily returns for Tastegood, market and risk-free asset during the event window

Required

You are to prepare a report, to present to the CEO, based on the Excel analysis you conduct for Part 1 and Part 2.

Part 1

Show the various cash flows based on the different scenarios; assuming that the Tastegood decides to proceed with the supply of private label confectionery to Cheap & Good; taking into consideration of the various scenarios. Show all formulae, adjacent to the corresponding calculated amounts in the spreadsheet. You should also clearly state any assumptions (if any) made in your analysis.

Part 2

Using Capital Asset Pricing Model (CAPM), calculate the daily abnormal return of Tastegood during the event window and plot it on a diagram. Daily abnormal return is computed as:

Abnormal Return = Actual Return - Expected Return (1)

Discuss the abnormal return pattern of Tastegood before, during and after the announcement and justify whether the stock price reaction is consistent with semi-strong form market efficiency. Your response should also include: (1) whether the abnormal return pattern is consistent with the analysis conducted from Part 1; (2) recommendations to exploit mispricing opportunities, if any, from the perspective of the company; and (3) expectations of what would happen to the share price subsequent to the analyzed event window.

Attachment:- Assignment.rar