Question 1 capital expenditure decisions and investment

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Reference no: EM13371636

Question 1: Capital Expenditure Decisions and Investment Criteria

In recent years Morten Ltd, a company that manufactures and markets a range of pharmaceutical products, has been highly profitable. Its success has been based to a large extent on its ability to generate and market new and innovative products on a regular basis. The latest of these products has just completed various tests to ensure it meets regulatory requirements and a decision now has to be taken on whether or not to proceed with an investment in the facilities required for manufacturing the product. You are required to undertake an evaluation of this potential investment.

The company has already spent $ 800,000 on the research programme from which this product has emerged. A number of other products are expected to get to the testing stage within the next few months. While is impossible to allocate accurately the expenditure incurred to the different products generated by the research programme it is agreed that the development of the product under consideration accounts for at least 40 per cent of the programme's expenditure of $ 800,000.

The company will have to cover the cost of further testing of the product to be undertaken by the regulatory body and this is expected to be about $ 90,000. The development director is very confident that the tests will be successful as they have already been rigorously undertaken by the company and no problems were identified.

The company anticipates that the product will remain competitive for the next five years after which it is likely to be displaced by the new products that are always being developed as the underlying technology evolves. In the first year it is anticipated that 200,000 units will be sold at a price of $ 12. From year two through to year four sales are expected to be 300,000 units per annum but are expected to fall back to 200,000 units in year five. It is anticipated that the price of the product will remain unchanged over the five year period.

The machinery required for the manufacture of the product will cost $ 1,200,000. It will have to be depreciated for tax purposes on the basis of an annual 25 per cent writing down allowance (ie. 25 per cent of the remaining book value of the asset having allowed for the allowances claimed in previous years). At the end of the five year period the machinery will be sold or, if it is more profitable, used in the manufacture of other products. The resale value of machinery of this nature after being used for five years is likely to be about 30 per cent of its purchase price.

The cost of the labour and materials required for the manufacture of the product has been estimated at $7.50 per unit, with materials accounting for 40 per cent of the cost and labour the residual 60 per cent. There are also fixed costs of $ 150,000 per annum stemming from the manufacturing process. The initial marketing of the product will cost $ 250,000 and the sales support per annum will cost $ 100,000. It is anticipated that the company will have to invest in working capital - holding finished products equivalent to 20 per cent of next year's sales, 25 per cent of the materials required for the next year, and it is expected that debtors and creditors will just about offset each other. The tax rate is 40 per cent and the required rate of return on investments of this nature is 16 per cent.

a) Determine the investment's net present value, the internal rate of return, payback period and the discounted payback period. All key assumptions should be specified and explained and an interpretation provided of results for each of the investment criteria specified. You should identify the costs and benefits that you think should be included in a rational decision making process. (This part of the question should be completed on the basis that the expected rate of inflation is zero.)

b) Assess how sensitive the calculated NPV is to three inputs (sale price, sales quantity and cost of investment) employed in the analysis. Provide an interpretation of your results and comment on how valuable you think this analysis may be in taking a decision on the investment.

c) Assume that the annual rate of inflation is expected to be 4 per cent per annum for the next five years. Also assume that the required rate of return of 16 per cent you employed above doesn't incorporate an allowance for the expected rate of inflation of 4 per cent. Explain how you would take the expected rate of inflation into account in a revised analysis and re compute the NPV of the project.

Question 2: Leasing

Download the annual reports of five (5) publicly listed companies from NZX. Look for information on special-purpose vehicles, operating leases, financial leases and sale-and leasebacks. In each case, decide whether the financing is long-term or short-term and how it affects the debt to equity ratio of each firm. Do you see evidence that leasing is used as a substitute for debt? Alternatively, is it used as a complement to debt? Write a report on your findings providing all relevant computations.

(The following journal article could be of help: Raung Lin, J et al (2013) 'Financial constraint and the choice between leasing and debt', International Review of Economics and Finance, Vol. 27 pp 171-182)

Question 3: Valuation of Shares

Identify the (current) price earnings ratios for three companies traded on the NZX and indicate how the ratio has changed over the last five years. Discuss the factors that might explain the differences between the price earnings ratios for the three companies and the changes that have occurred in their price earnings ratios over the five year period. (Choose companies with a range of P/E ratios to give you one with a relatively low value, one with a relatively high value, and another with a middling value.

You should use the insights provided by valuation models on the determinants of the price-earnings ratios in your discussion, but you should also discuss the role of any other factors that might influence the reported values of price-earnings ratios of the companies you have chosen.

Question 4: Capital Structure

Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robert Stephenson. The company purchases real estate, including land and buildings, and rents the property to tenants. The company has shown a profit every year for the past 18 years, and the shareholders are satisfied with the company's management. Prior to founding Stephenson Real Estate, Robert was the founder and CEO of a failed alpaca farming operation. The resulting bankruptcy made him extremely averse to debt financing. As a result, the company is entirely equity financed, with 12 million shares of common stock outstanding. The stock currently trades at $48.50 per share.

Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern New Zealand for $45 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson's annual pretax earnings by $11 million in perpetuity. Kim Weyand, the company's new CFO, has been put in charge of the project. Kim has determined that the company's current cost of capital is 11.5 percent. She feels that the company would be more valuable if it included debt in its capital structure, so she is evaluating whether the company should issue debt to entirely finance the project. Based on some conversations with investment banks, she thinks that the company can issue bonds at par value with a coupon rate of 7 percent. Based on her analysis, she also believes that a capital structure in the range of 70 percent equity/30 percent debt would be optimal. If the company goes beyond 30 percent debt, its bonds would carry a lower rating and a much higher coupon because the possibility of financial distress and the associated costs would rise sharply. Stephenson has a 40 percent corporate tax rate.

  1. If Stephenson wishes to maximize its total  market value, would you recommend that it issue debt or equity to finance  the land purchase? Explain.
  2. Compute Stephenson's market value of equity before  it announces the purchase.
  3. Suppose Stephenson decides to its interna lly generated funds to finance the purchase.
    •  What is the net present value of the  project?
    • What would be the new price per share of the  firm's stock?
  4. Suppose Stephenson decides to issue new sha res to finance the purchase instead of its internally generated funds: How  many new shares should Stephenson issue and construct Stephenson's market value balance  sheet after the purchase has been made.
  5. Suppose Stephenson decides to issue debt to finance the purchase:
       What  will the market value of the Stephenson's Company?
    • What would be the new per share value?
  6. Which method of financing maximizes the  per-share stock price of Stephenson's equity? Explain.

Question 5: Weighted Average Cost of Capital

Defence Electronics International (DEI) a large publicly listed company is the market leader in radar detection systems (RDSs). The company is looking to set up a manufacturing plant overseas to produce a new line of RDSs. This will be a five year project. The company bought a piece of land three years ago for $ 7 million in anticipation of using it as a toxic dump site for waste chemicals, but instead built a piping system to discard chemicals safely. If the company sold the land today it would receive $ 6.5 million after taxes. In five years the land can be sold for $4.5 million after taxes and reclamation costs. DEI wants to build a new manufacturing plant on this land. The plant will cost $15 million to build. The following market data on DEI's securities are current:

Debt

150,000, 12% coupon bonds outstanding with 15 years to maturity redeemable at par, selling for 80 percent of par; the bonds have a $100 par value each and make semi annual coupon interest payments.

Equity

300,000 ordinary shares, selling for $75 per share

Non-redeemable Preference shares

20,000 shares (par value $ 100 per share) with 7.2% dividends (before taxes), selling for $72 per share

The following information is relevant:

  1. DEI's tax rate is 30%
  2. The company had been paying dividends on its  ordinary shares consistently. Dividends paid during the past five years  is as follows

Year (-5) ($)

Year (-4) ($)

Year (-3) ($)

Year (-2) ($)

Year (-1) ($)

2.2

2.5

2.8

3.3

3.6

  1. The project requires $ 900,000 in initial net  working capital investment in year 0 to become operational.
  2. Work all solutions to the nearest two decimals.

Required:

  1. Calculate the project's initial, time 0 cash flow, taking into  account all side effects.
  2. Compute the current weighted average cost of capital (WACC) of DEI.  Show all workings and state clearly the assumptions underlying your  computations.
  3. Using the WACC computed in part (2) above and assuming the following, compute the project's Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability Index (PI)
    1. The manufacturing plant has a ten-year tax like and DEI uses straight  line method of depreciation for the plant. At the end of the project,  (i.e. at the end of year 5), the plant can be scrapped for $ 5 million.
    2. The project will incur $400,000 per annum in fixed costs
    3. DEI will manufacture 15,000 RDSs per year in each of the years and  sell them at $ 1,000 per machine.
    4. The variable production costs are $ 500 per RDS.
    5. At the end of year 5, the company will sell the land.
  4. The new RDS project is somewhat riskier than a typical project for  DEI, primarily because the plant is being located overseas. Explain  briefly how DEI could accommodate this additional risk factor in the  determination of its discount factor?

Reference no: EM13371636

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