GUIDELINES
- This assignment requires students to prepare a detailed business report based on a case study by applying financial concepts such as capital structure, capital budgeting, and others in topics 1-7 in the course.
- This is a group assignment marked out of 100 and contributes 30% of your overall assessment for FIN1FOF. Students need to form a group of three to complete this assignment.
Your report must be submitted via “Assignment Dropbox” on the FIN1FOF subject LMS site by 11:59 pm on Sunday 8th May 2022. Hard copies will not be accepted. Make sure you have successfully attached your submission before submitting and exiting the Dropbox. Make sure you receive an email confirmation of your submission. If you aren’t sure, go back into Dropbox and check that your submission is attached.
SCENARIO
Your team of three works in the Finance division of the Carlton Manufacturing Company Ltd. The company is in the process of deciding whether or not to purchase a new plastic injection machine. Your company’s Chief Financial Officer has asked you to make a recommendation as to whether or not the company should proceed with the project based on the following information:
A. Balance sheet and notes
| Carlton Manufacturing Company Ltd | ||||
| Balance Sheet as at 31/12/21 | ||||
| ASSETS | LIABILITIES | Notes | ||
| Cash | 140 | Accounts payable | 120 | |
| Accounts Receivable | 200 | Bank loan (interest only) | 1 | 240 |
| Inventory | 610 | Mortgage Loan | 2 | 530 |
| Property, plant & equipment | 1,200 | Corporate bonds | 3 | 300 |
| Total Assets | 2,150 | Total liabilities | 1,190 | |
| SHAREHOLDERS’ EQUITY | ||||
| Ordinary shares | 4 | 430 | ||
| Preference Shares | 5 | 250 | ||
| Retained earnings | 280 | |||
| Total shareholders’ equity | 960 | |||
| Total liabilities and shareholders’ equity | 2,150 |
Notes
- The interest rate on the bank loan is 8.2% p.a.
- The interest rate on the mortgage loan is 5.9% p.a.
- The corporate bonds have a credit rating of AA and have 2 years to maturity. They make quarterly coupon payments at a coupon rate of 7% p.a.
- The ordinary shares are shown on the balance sheet at their book value of $1 per share. They have a beta of 1.2. They have just paid a dividend of $0.07. The dividend is expected to grow at a rate of 7% p.a. for the next 3 years, and after that, it will grow at a constant rate of 3% p.a. in perpetuity.
- The preference shares have a par value of $1 each and are shown on the Balance Sheet at their par value. They pay a constant dividend of $0.10, and they are currently trading for
$1.2.
- The risk premium for ordinary shares is 8%.
- The corporate tax rate is 30%. The 2-year risk-free rate is 0.03%. The 10-year risk-free rate is 1.14%
B. Credit Spread
| Rating | 1 yr | 2 yr | 3 yr | 4 yr | 5 yr | 6 yr | 7 yr | 8 yr | 9 yr | 10 yr |
| AAA | 128 | 168 | 208 | 248 | 288 | 328 | 368 | 408 | 448 | 488 |
| AA+ | 139 | 179 | 219 | 259 | 299 | 339 | 379 | 419 | 459 | 499 |
| AA | 150 | 190 | 230 | 270 | 310 | 350 | 390 | 430 | 470 | 510 |
| AA- | 161 | 201 | 241 | 281 | 321 | 361 | 401 | 441 | 481 | 521 |
| A+ | 172 | 212 | 252 | 292 | 332 | 372 | 412 | 452 | 492 | 532 |
| A | 183 | 223 | 263 | 303 | 343 | 383 | 423 | 463 | 503 | 543 |
| A- | 194 | 234 | 274 | 314 | 354 | 394 | 434 | 474 | 514 | 554 |
| BBB+ | 205 | 245 | 285 | 325 | 365 | 405 | 445 | 485 | 525 | 565 |
| BBB | 216 | 256 | 296 | 336 | 376 | 416 | 456 | 496 | 536 | 576 |
| BBB- | 227 | 267 | 307 | 347 | 387 | 427 | 467 | 507 | 547 | 587 |
| BB+ | 238 | 278 | 318 | 358 | 398 | 438 | 478 | 518 | 558 | 598 |
| BB | 249 | 289 | 329 | 369 | 409 | 449 | 489 | 529 | 569 | 609 |
| BB- | 260 | 300 | 340 | 380 | 420 | 460 | 500 | 540 | 580 | 620 |
| B+ | 271 | 311 | 351 | 391 | 431 | 471 | 511 | 551 | 591 | 631 |
| B | 282 | 322 | 362 | 402 | 442 | 482 | 522 | 562 | 602 | 642 |
| B- | 293 | 333 | 373 | 413 | 453 | 493 | 533 | 573 | 613 | 653 |
| CCC+ | 304 | 344 | 384 | 424 | 464 | 504 | 544 | 584 | 624 | 664 |
| CCC | 315 | 355 | 395 | 435 | 475 | 515 | 555 | 595 | 635 | 675 |
| CCC- | 326 | 366 | 406 | 446 | 486 | 526 | 566 | 606 | 646 | 686 |
| CC | 337 | 377 | 417 | 457 | 497 | 537 | 577 | 617 | 657 | 697 |
| C | 348 | 388 | 428 | 468 | 508 | 548 | 588 | 628 | 668 | 708 |
- Project Information
- The equipment will cost $720, is expected to have a working life of 4 years, and will be depreciated on a diminishing-value basis to a book value of zero.
- The equipment is expected to have a salvage value of $120 at the end of 4 years.
- The new equipment will improve efficiency and result in increased revenue of $850 in its first year of operation, but because of reduced efficiency from normal wear and tear, revenue will decrease by 4% (from the previous year’s revenue) for each of the remaining 3 years of the equipment’s life.
- Excluding maintenance, all other costs from operating the equipment will be $280 per year. Maintenance costs will amount to $120 in the equipment’s first year of operation and will then increase by $30 per year for the remaining 3 years of the equipment’s life.
- The equipment will require additional net working capital of $200. The net working capital will be recovered in full after the equipment is sold at the end of its working life.
- The equipment will be installed in a building that is owned by the company but currently is not being used. If the project does not proceed, this building could be rented out for $200 per year.
- A feasibility study has been undertaken on the purchase of the new equipment. The cost of preparing the feasibility study was $400.
- The company has sufficient capital to undertake all positive-NPV projects. If the Payback Period method is used to evaluate projects, management’s policy is that the maximum acceptable payback period is 3 years, and all cash flows in Year 0 would need to be recovered within 3 years for the project to be acceptable under this method.
TASKS
You are required to complete the following tasks (show your working with the calculations):
Part 1: Calculate the company’s Weighted Average Cost of Capital (30 marks)
- Calculate the before-tax cost of bank loans, mortgage loans, and corporate bonds (6 marks).
- Calculate the (market) value of bank loans, mortgage loans, and corporate bonds (6 marks).
- Calculate the cost of ordinary shares and preference shares (6 marks).
- Calculate the market prices of ordinary shares and preference shares (4 marks).
- Calculate the total market values of ordinary shares and preference shares (4 marks).
- Calculate the company’s WACC (4 marks).
Part 2: Estimate the project’s incremental free cash flows (30 marks)
- Prepare the depreciation table of the equipment (see examples in Topic 7 seminar). Round up to whole numbers (10 marks).
- Prepare the free cash flow table (see examples in Topic 7 seminar). Round up to whole numbers (20 marks).
Part 3: Calculate the project’s NPV, Payback Period, and Profitability Index (20 marks)
- Calculate NPV, Payback Period, and Profitability Index (10 marks).
- Should the project be accepted? Explain your answer (10 marks).
Part 4: Evaluate the company’s capital structure (20 marks)
- The Carlton Manufacturing Company Ltd belongs to the Industrial sector. Identify three Industrial firms listed on the ASX, observe their debt ratios over the last five years, and determine whether the company is under or over-leveraged relative to its peers (no more than 200 words) (10 marks).
- Discuss the advantages and disadvantages of debt financing (no more than 300 words) (10 marks).
