SECTION A – 50 MARKS
[Note: the indicative time for answering this section is 90 minutes]
ANSWER THIS QUESTION
Unseen material for Case Study
Today’s date is 27 May 2010.
The Specialist Components division (SC) of Aybe has recently been successful in researching and developing a new state-of-the -art range of products with the help of a research faculty in the USA. These are now ready to be produced. They will be sold in Europe and the USA.
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In order to manufacture the new products, major investment is required. Aybe is considering two alternative ways forward:
- Project 1: The complete refit of SC’s factory located in the home country, Country C.
- Project 2: Build a factory in the USA in a designated development area where a government grant would be available towards the cost of construction.
The new products will be priced in US$ for all worldwide sales. Each project is to be evaluated over a 5 year time period, referred to internally as the ‘planning horizon’. The period commences 1 January 2011.
Note: Only one project will be undertaken.
Project 1 – Factory refit in Country C
The current factory would need to be refitted to accommodate the new product range but would then continue producing the current products alongside the new product range. It is estimated that the disruption to production of the current products would result in a loss of up to three or four months operating profit, that is, approximately C$4million (pre-tax cash loss) in 2011. Specialist consultants from the USA may also be needed to oversee the development and manage the manufacturing process but no figures are available for these costs at this time.
- The cost of the factory refit is estimated to be C$35million, payable in 2011. The residual value is estimated to be C$4million at the end of 5 years.
- Pre-tax operating cash flows from the new product line begin in 2012 and annual cash flows are forecast to be:
o Cash inflows: US$160million a year o Cash outflows: C$30million a year.
- Tax relief on the cost of the factory refit is available at a rate of 50% in the first year and then at 25% on a reducing balance basis in subsequent years; balancing charges are charged on any residual values.
- The corporate tax rate in Country C for the period of the project is 25% and the tax is paid in the period in which it arises.
- This project is to be evaluated at an after-tax discount rate of 8%.
Project 2 – New factory in the USA
A possible site for a new factory has been identified in the USA. A significant amount of interest has been expressed in the site by other potential developers. As a precautionary measure, therefore, on 1 May 2010 Aybe paid a fee of US$200,000 for the option of purchasing the full ownership rights of the land at any time up to 1 January 2011 at an agreed price of US $20million. It was considered that eight months would allow sufficient time for Aybe to apply for the necessary planning permission to construct the manufacturing facility on the site and also to carry out a more detailed financial assessment of the proposed investment.
If a new factory were to be built in the USA, Aybe would be eligible for a grant of US$15million in each of the first three years of the project, with the first of the three payments being made at the end of 2012. The grant is a revenue grant towards employee and other operating costs and is not repayable as long as certain conditions are met. Corporate tax is payable on the grant at the standard rate.
The new USA operation would be set up as a separate legal entity which would be a subsidiary company of Aybe.
- Assume the land is purchased on 1 January 2011.
- The development cost (excluding land) is estimated as US$120million, with half this sum payable at the end of 2011 and the other half at the end of 2012.
- The residual value of the project at the end of 2015 is estimated as US$40million, including US$20million for the land.
- Net pre-tax operating cash inflows from the new product line begin in 2012 and are forecast to be US$50million per annum (excluding the grant).
- Tax relief on the development cost is at a rate of 100% in the first year and balancing charges are applied to any residual value. No tax relief is available on the purchase of the land.
- For simplicity and for the purposes of this question, assume that the relevant corporate tax rate in the USA is 30% and that tax is paid in the period in which it arises.
- Assume that no further tax is due or refundable in Country C in respect of this project.
- This project is to be evaluated at a higher after-tax discount rate of 11% to reflect the increased risk of a foreign project.
Additional financial information applicable to both projects
- The C$/US$ exchange rate is expected to be C$/US$4.000 on 31 December 2010 (that is, C$1=US$4.000) and the US$ can be assumed to strengthen against C$ by 5% a year in 2011 and subsequent years.
- All cash flows arise at the end of the year, unless otherwise stated.
- Assume cash flows are nominal cash flows, that is, they include assumptions on inflation.
Assume you are an external consultant engaged by Aybe to evaluate the proposed projects. Write a report, suitable for presentation to the Directors of Aybe, in which you:
- Calculate the Net Present Value (NPV) of each of Project 1 and Project 2 as at 1 January 2011 for the 5 year planning horizon. State any assumptions made.
- Evaluate how other relevant factors such as changes to the planning horizon might affect the choice of project and advise Aybe how to proceed.
Up to 6 marks are available for calculations.
- Advise on the choice of currency if long term borrowings should be required to finance the new USA subsidiary in Project 2.
- Advise the Directors on how to achieve efficient management and control of the implementation of the proposed projects. Your answer should include discussion of the different issues arising for each project.
Additional marks available for structure and presentation. (3 marks)
(Total for Question One = 50 marks)
(Total for Section A = 50 marks)
[Note: the indicative time for answering this section is 90 minutes] ANSWER TWO OF THE THREE QUESTIONS – 25 MARKS EACH
PIC is a furniture retailing company in a developed country in Asia. It has 15 stores spread around the country. Each store has some freedom to adapt its buying patterns to local market conditions although around 80% of its products must be obtained through central purchasing. Sales receipts are paid to head office on a monthly basis. PIC offers 60-day credit to a few key high-profile and agency customers who account for a substantial proportion of sales by value. However, the majority of customers pay immediately by cash.
The treasurer has observed that working capital levels fluctuate quite substantially from month to month. Based on forecast revenue for next year, the average days and minimum and maximum working capital levels for next year are likely to be as follows:
At present PIC follows an aggressive policy for financing net current assets. All fluctuating net current assets and 20% of permanent net current assets are funded by overdraft. PIC currently has an overdraft facility of up to A$20million, secured as a floating charge on the entity’s current assets. Interest is charged at 7% (pre-tax) on daily balances. Over the past year PIC has used its maximum overdraft facility. The treasurer thinks this is too risky a policy in present economic conditions and is proposing a more conservative policy where 100% of permanent net current assets and 20% of fluctuating net current assets are financed by medium or long term finance. To achieve this, PIC is proposing to issue a bond, redeemable at par in 5 years’ time, with an annual coupon of 8%. Interest would be paid annually at the end of each year. Other similar corporate bonds have a yield to maturity of 9%.
PIC’s shares are listed on a secondary market. The market value of the shares is currently A$350 million and its cost of equity is 10%. PIC also has long term debt in issue with a market value of A$100 million at an average pre-tax cost of 8.125%. PIC pays corporate tax at 20%.
The requirement for Question Two is on the opposite page
- Calculate the short-term and long-term (permanent) financing requirements of PIC under the aggressive policy for financing net current assets that is currently being used and also under the proposed new conservative policy.
- Calculate the implied issue price per A$100 nominal of the bond being considered by the treasurer.
- Calculate the weighted average cost of capital (WACC) of PIC at present and discuss, briefly, the likely effect on WACC if PIC changes its policy for financing net current assets.
- Evaluate PIC’s proposal to change from an aggressive to a conservative policy for financing net current assets.
- Advise PIC, briefly, on alternative approaches to financing net current assets that it should consider.
(Total for Question Two = 25 marks)
A REPORT FORMAT IS NOT REQUIRED IN THIS QUESTION
XK is a multinational manufacturer of household electrical goods. Its headquarters and main manufacturing base are in the USA. Each manufacturing operation is usually established as a separate wholly-owned subsidiary. The larger electrical appliances tend to carry higher margins and there is a general move away from manufacturing smaller appliances.
Extracts from XK Group’s latest statement of financial position at 30 April 2010:
|EQUITY AND LIABILITIES|
|Share capital (Common shares of US$1)||375|
|Secured 7.5% bonds repayable 2020||1,000|
|Total equity and liabilities||2,950|
- XK’s bonds are secured on its non-current assets.
- The current liabilities include overdraft of US$150 million. The conditions of the overdraft require XK to maintain a current ratio of at least 1.5 : 1.
- Group earnings for the year to 30 April 2010 were US$510 million.
- XK pays corporate tax at 25% per annum.
- XK’s share price has risen 5% over the past 3 months to its present level of US$8.75. The stock market price index has fallen by 3% in the same period.
The XK Board is discussing the divestment of one of its US subsidiaries, Company Y, which manufactures smaller appliances. Historically, the subsidiary company, Y, has accounted for 6% of group earnings. XK’s accountants, with some input from the subsidiary’s management team, have determined a net present value (NPV) to be placed on Company Y of US$325million. The Executive Directors of Y believe they can transform the business if they have the freedom to respond to market challenges and are considering a management buy out (MBO).
Financing the MBO:
The financing of the MBO will be by a combination of funding from the Executive Directors of Y, an investment bank and a Venture Capitalist.
The Executive Directors of Y expect to be able to raise US$5million between themselves as equity.
The investment bank will lend a maximum of 90% of the non-current assets of the business secured on those non-current assets, which are valued in the accounts at US$220 million. The interest rate will be 6% and the principal will be repayable in 5 years’ time. This rate compares with current prime, or base, rate of 2% and commercial bank secured lending rates of between 3% and 4%.
The venture capitalist will supply the balance of the funding required. The venture capitalist expects a return on its investment averaging 25% per annum (on a compound basis) by 31 March 2015 and requires all earnings to be retained in the business for 5 years. Some of the MBO team are not happy with this requirement.
- Evaluate the interests of the various stakeholder groups in both XK and its subsidiary Company Y, and how these might be affected by the divestment.
- Discuss the economic and market factors that might impact on the negotiations between XK and the various financiers of the divestment (the Executive Directors of Y, the investment bank and the venture capitalist).
- Evaluate the advantages and disadvantages of the proposed buyout structure, and recommend alternative financing structures for the buyout.
Up to 5 marks are available for calculations
(Total for Question Three = 25 marks)
CIP is a family-controlled company. The family owns 80% of the shares. The remaining 20% is owned by a number of non-family shareholders, none of whom owns more than 1% of the shares in issue. The Board of Directors has convened a special Board meeting to review two investment opportunities and, at the request of the new Finance Director, decide on an appropriate discount rate, or rates, to use in the evaluation of these investments. Each of the two investments being considered is in a non-listed company and will be financed 60% by equity and 40% by debt.
In the past, CIP has used an estimated post-tax weighted average cost of capital of 12% to calculate the net present value (NPV) of all investments. The Managing Director thinks this rate should continue to be used, adjusted if necessary by plus or minus 1% or 2% to reflect greater or lesser risk than the “average” investment.
The Finance Director disagrees and suggests using the capital asset pricing model (CAPM) to determine a discount rate that reflects the systematic risk of each of the proposed investments based on proxy companies that operate in similar businesses. The Finance Director has obtained the betas and debt ratios of two listed companies (Company A and Company B) that could be used as proxies. These are:
|Company A (proxy for Investment 1)||1.3||0.3||1:3|
|Company B (proxy for Investment 2)||0.9||0||1:6|
- The expected annual post-tax return on the market is 8% and the risk-free rate is 3%.
- Assume the debt that CIP raises to finance the investments is risk-free.
- All three companies (CIP, Company A and Company B) pay corporate tax at 25%.
- CIP has one financial objective, which is to increase earnings each year to enable its dividend payment to increase by 4% per annum.
The Managing Director and the other Board members are confused about the terminology being used in the CAPM calculation and do not understand why they are being asked to consider a different method of calculating discount rates for use in evaluating the proposed investments.
- Discuss the meaning of the terms “systematic” and “unsystematic” risk and their relationship to a company’s equity beta. Include in your answer an appropriate diagram to demonstrate the difference between the two types of risk.
- Using the CAPM and the information given in the scenario about CIP and Companies A and B, calculate for each of CIP’s proposed investments:
- An asset beta.
- An appropriate discount rate to be used in the evaluation of the investment.
- Evaluate the benefits and limitations of using each of the following in CIP’s appraisal of the two investments:
- CIP’s WACC.
- An adjusted WACC as suggested by the Managing Director.
- CAPM-derived rates that use proxy (or surrogate) companies’ betas.
- Discuss, briefly, how an asset beta differs from an equity beta and why the former is more appropriate to CIP’s investment decision. Include in your discussion some reference to how the use of the CAPM can assist CIP to achieve its financial objective.
(7 marks) (Total for Question Four = 25 marks)
A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION
(Total for Section B = 50 marks)