QUESTION
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INSTRUCTIONS
Instructions
1. Your answers for the assignment questions are to be type written and submitted by the due
date. Extensions beyond the due date will only be granted in exceptional circumstances
and must be requested by email and approved in advance of the due date by the course
coordinator.
2. Ensure your answers fully document the working used for each question as some marks
are awarded for evidence that the correct process has been used. For example, to calculate
the present value of a future amount the following documentation is required
1,000 +/- FV, 8 N, 2.5 I/Y, COMP PV giving $820.75, whereas just providing the correct
answer will only receive minimum marks
Word limit
The word limit indicated for questions included in this assignment excludes any calculations
and has been included as a guide to assist you to address each question fully but succinctly
and to not include irrelevant information. You can provide a slightly greater number of words
than the recommended limit if you consider it necessary to enhance your discussion.
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Question 1 (Total marks for this question = 33)
Although Oz-seafoods Limited is an Australian Stock Exchange listed company, 88% of its
ordinary shares are owned by a large United Statesfood company that is wholly owned by
shareholders located in the United States and Canada. The major activity of Oz-seafoods is to
purchase live Southern Australia crayfish which it packages into long-chillpolystyrene
containers that are air freighted and sold to restaurants in Hong Kong and mainland China.
Currently the company ships 200,000 containers of crayfishper year and it expects this
volume to be maintained into the future.
For some time Oz-seafoods has been buying its long-chill polystyrene containersfrom a local
supplier at a price of $2.00per container . In recent discussions, the supplier has indicated
that it is prepared to enter into a long-term contract to supply the company with its annual
requirement for long-chill polystyrene containers at afix edprice of $1.60 per container.
However, Oz-seafoods’ operations manager believes that it would be cheaper for the
company to make the containers itself rather than buy themfrom the supplier and has
obtained a quote of $150,000 to purchase the necessary machine to make the containers. This
machine has an anticipated operational life of 10 years with no salvage value.
However, as a result of the federal government’s economic stimulus initiatives, the company
canf or taxation purposesfully depreciate the total cost of the machine on a straight-line
basis over a 7 year term. In addition, Oz-seafoods’ operations manager has ascertained that
the company can enter into contracts that willfix for a number of years the direct material
and labour costs to manufacture thepolystyrene containers at $1.50 per container.
The operations manager has also estimated thatproduction of the containers would require
additional working capital of $30,000 each year allocated as; investment in debtors $14,000
and investment in initial materials inventory of $16,000. However the company’s
accountant argues that this sum ($30,000) should be ignored in any financial evaluation as it
is expected to befully recover ed during the last year that the machine will be operational.
Oz-seafoods Ltd pays Australian company tax at a marginal rate of 30%. All tax cash flows
(payable or saving) are assumed to occur at the end of the same year that taxable income is
earned. Also the total of all operating cash flows that occur during a year are assumed to be
timed at the end of that year.
The managing director of Oz-seafoods Ltdfeels that the company must reach a decision
about thepolystyrene container manufacturingproject’s implementation. Oz-seafoods Ltd
has a current ordinary share price of $1.80 and has sufficient cash reserves and debt-rating
to fund thepurchase of the new machine at the same debt: equity ratio as is currently
applying for the company. Its most recent (abbreviated) balance sheet is as follows:
OZ-SEAFOODS LIMITED
($ million) ($ million)
Liabilities Assets
Current $5 Current $10
Long term Debt1 $20 Non Current $30
Equity2
10m fully paid ordinary shares $10
Retained Earnings $5
$40 $40
1. Comprises bonds with average maturity 10 years; average coupon rate (paid half-yearly)
10.7% per annum. The current yield on company debt of similar rating is 9% per annum,
which is 6% per annum above the yield on government bonds of similar maturity.
2. Current company beta is 1.74
2
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Oz-seafoods’ managing director has commissioned an economist who hasprovided an
estimate of 2% p.a. for the long-term rate of inflation and an expectation that the market
portfolio will on average provide a return of 7%p.a. above government securities.
Required:
a) Specify whether the evaluation of Oz-seafoods Ltd’s capital budgeting projects
should be undertaken on a pre-tax or after-tax basis.
Briefly justify your response. (100 words). (3 marks)
b) Over how many years should Oz-seafoods’ capital budgeting evaluation of the
polystyrene container manufacturingproposal be undertaken?
Briefly justify your response. (50 words). (2 marks)
c) Do you agree or disagree with the accountant ’s argument regarding the working
capital outlay being ignored in the evaluation of the capital budgeting project?
Briefly justify your response. (50 words) (2 marks)
d) To determine the weighted average cost of capital that the company should use to
evaluate its investment projects, calculate the appropriate measure of:
(i) Cost of Debt (2 marks)
(ii) Value of Debt (3 marks)
(iii) Cost of Equity (3 marks)
(iv) Value of Equity (1 mark)
(v) Weighted Average Cost of Capital. Round your calculated answer to the nearest
whole percentage (e.g. 12.37% = 12%, 18.84% = 19%) (1 mark)
e) To evaluate the capital budgetingproject to manufacture polystyrene containers:
i) Calculate the company’s initial outlay. (2 marks)
ii) Using the format of the worksheet (below) set out the amount and timing of
all the relevant incremental (differential) operating net cash flows for each
year of the project. (10 marks)
Note that the worksheet below is only an example of the required format and
does not contain all the columns, rows and items you will need to use.
You are also required to provide Notes after the worksheet explaining your
calculations and any assumptions you make and cross-reference them to the
cash flow amounts shown in the worksheet.
$, (outflows shown in brackets)
Year 1 (end year 1) Year 2 …….
Operating Net Cash Flow1
Notes:
1.
2.
3
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iii) Calculate the company’s terminal cash flows (ignoring any annual
operating cash flow amounts) for th e finalperiod. (1 mark)
iv) Draw a cash-flow diagram / timeline detailing the incremental net cash
flows for each time period for the polystyrene container manufacturing
project . (1 mark)
f) Calculate the net present value of thepolystyrene container manufacturing project.
(1 mark)
g) What is your recommendation about proceeding with thepolystyrene container
manufacturing project?
Briefly justify your response. (50 words). (1 mark)
Question 2 (Total marks for this question = 7)
Gino and Mario are two brothers who have recently entered into a partnership together to
establish apasta manufacturing and retail business. They are currently in the process of
evaluating two models ofpasta making machinefor installation in the ir manufacturing
premises . Their business is all equity financed and they consider that an after-tax rate of
return of 12% p.a. on their savings invested in the business is appropriate given the risk of the
venture and that in the current economic conditions they would only receive 5% p.a.pre -tax
from a bank fixed deposit. The specifications of eachpasta making machine are detailed
below:
Machine A Machine B
Purchase & Installation Cost $70,500 $100,000
Useful Life 8 years 10 years
Annual after-tax costs of operating machine $13,750 $10,000
After -tax cost of machine service every 2 years $6,250 $3,000
Note: Assume all expenditures occur at the end of each period and the impact of
depreciation has been included in the determination of the after-tax costs to
operate each machine. There is no service of the machine in its last year of
operation.
Required:
a) For each pasta making machine, draw a time line identifying its cash flows
and calculate the net present value to purchase the machine. (3 marks)
b) (i) Based only on your NPV calculations above, recommend to the brothers
which pasta making machine they shouldpurchase?
Briefly justify your response. (50 words). (1 mark)
ii) Briefly discuss if there is aproblem with this recommendation.
(50 words). (1 mark)
c) Using the Equivalent Annual Annuity method determine and recommend which
machine the brothers should purchase. (2 marks)
TOTAL 40 MARKS
SOLUTION
Question 1
a) The evaluation shall be undertaken on after tax basis. This is because the shareholders are from America having 88% share in the company. The main interest will be on return to them rather than operational profit being made by the company.
b) For the evaluation of polystyrene container manufacturing the project life should be considered as seven years rather than ten years which is actual expected life because this will be the basis for depreciation and this will be the basis for estimating the benefits that the company will be able to take the operations and thus generate income.
c) The working capital outlay cannot be ignored as the present value of the initial working capital is $30,000 and if the life of the period is taken to be seven years. The present value of the working outlay will be much less than $30,000. Thus although it will be fully recovered the present value of the company cannot be ignored.
d) Cost of debt is given by
Cost of equity
Rp=Rf + β (Rm-Rf)
Rf=3%
Rm=7%
Β=1.74
Thus the cost of equity= 3 + 4*1.74 = 9.96%
Value of equity
Number of share * Value of shares
=10,000,000*1.8 =$18,00,000
Weighted average cost of capital is
cost of debt*amount of debt + cost of equity*amount of equity
e) Initial Outlay Calculations
The company has 20 million in debt and 15 million in equity. Thus the ratio of debt to equity is 4:3. The cost of the machine will have the same structure. Thus the initially the company will have to raise debt for $150,000 machine will be 150,000*4/7=$85,714 and the equity will be 64,296. Rest all the calculations are shown in the sheet
f) All the calculations are shown in the sheet
g) The company may not go in with the purchase of the machine. The reason for this is that for manufacturing the containers by purchasing the machine will only result in reduction of cost by $0.10 per container. This will be much more than the cost the company will pay for the debt raised to purchase the machine. Also the net present value of the extra expense will result in lesser present value of cost.
Question 2
a) The diagram for both machines in the enclosed excel
b) Based on the net present value of the outflow it can be said that the Net Present Value of the cash outflow is less for the Machine 1 and thus machine 2 should be purchased. The machine 1 has lower Net Present Value of the cash outflow because of the initial value of the machine is less than Machine 2.
The issue with this recommendation is that firstly it is assumed that both the machines will give the same output. Secondly the cash inflow has not been considered. Thus the exact decision can only be made after considering the cash inflow brought by the machines.
c) By Equivalent Annuity method the annuity factor is calculated for each machine
Machine 1: 6.46
Machine 2: 7.71
Thus this will result in reduced value of the netn present value. Thus based on this it can be said that machine 2 is better option as this will have reduced NPV and will bring in more inflows.
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