CORPFIN 7101 managerial finance
University of Adelaide Business School MANAGERIAL FINANCE
Assignment CASE 1
Sam Harrison has been working as a petroleum engineer for the last 10 years largely on offshore oil rigs in Western Australia. The fall in the price of oil and gas since the beginning of the COVID 19 pandemic has caused his company to reduce production and to cut the workforce on its rigs. Redundancy packages were offered to employees and Sam decided it was time to move back to Adelaide and to retrain in order to take up employment opportunities in the expanding carbon storage projects being undertaken in the Cooper Basin in South Australia. Taking into account his personal savings plus redundancy payment, Sam has managed to save $400,000 which currently is earning 1.2% annual interest in a term account with his bank. Sam plans to withdraw $300,000 from the account and invest it in shares.
In discussions with a financial advisor recommended by his bank, he understands that he should consider the advantages of investing in a portfolio and the concept of systematic risk. After considering a range of possible companies recommended by the financial advisor, Sam has decided that he would like to invest his money in two companies, namely York Mining Ltd and Torrens Solar Energy Ltd. The financial advisor recommends that Sam invest half his available funds in each company. However, Sam is not so sure this is the right approach to take. He recalls reading about betas and systematic risk, and after a search of various internet sites has found that shares in York Mining have a beta of 1.40, and shares in Torrens Solar Energy 0.8. In addition, he also noted that the general consensus amongst financial analysts is that the current expected return on the ASX 200 Index is 7.2% and the risk-free rate is 1.8%.
- Explain to Sam the significance of beta and the difference in beta between the shares in these two companies?
- What is the expected return on each of these shares?
- Suppose Sam is aiming to achieve a return of 8.5% on his funds invested in a portfolio consisting of these two shares. How much of his funds should be invested in each of these shares to achieve this return?
- What is the beta of the resultant portfolio?
- Would you support Sam’s investment strategy?
Assignment CASE 2
Nationwide Foods Ltd has been operating for seven years in Adelaide and has quickly established a strong reputation across the eastern states as a reliable supplier of high quality organic fruit, vegetables, meat and diary products to high-end clients such as hotels, restaurants, airlines and special event catering services. The foundation of the business is contracts with reputable producers across various regions in South Australia who are dedicated to producing organic food, the adoption of modern production and food handling technology, and very receptive to meeting the company’s specialist needs as its range of clients grows.
The business has grown rapidly since it commenced operations, supported by a successful IPO five years ago, and an issue of unsecured notes two year’s later.
The COVID 19 shutdown of states has had a profound impact on the business, especially sales to a number of key suppliers to hotels, restaurants, airlines and upmarket retail outlets. This has caused the company to consider export opportunities to make up for a very significant fall in produce sales to clients in Australia, something that it was planning to investigate in 2022, but now it has the time to explore this potential development.
It has recently been approached by representatives of Middle East airlines to consider opportunities for the export of the company’s fresh produce to the Middle East. The company subsequently decided to send two of its senior executives to the region to explore opportunities in July 2020, despite the need to quarantine on their return. Both have returned with encouraging reports. A trial shipment of produce to a distributor in Dubai in September was well received with the promise of follow up orders provided the company is able to maintain a steady flow of a wide range of fresh produce.
The company is aware that meeting the volume and quality requirements of clients in the Middle East will be a critical part of the development of a business model for exporting fresh produce to this region. It is also aware that its current processing and storage facilities are inadequate to support further growth of its business. It will need to build a new plant to facilitate the development of an export business. The company had purchased land close to Adelaide Airport some three years ago for $4.0 million in anticipation of expanding its business, and to be able to easily link its exports of perishable goods to the regular flight schedules of Qatar and Emirates airlines once they resume regular flights to the Middle East. This land would be the site of a new plant to facilitate an export business. The company recently received an offer of $4.5 million for the land. It is anticipated that the land will increase in value at the rate of 5% per annum for the foreseeable future.
In September you were asked by the CEO of the company to lead an evaluation team of key people from various parts of the company to develop the business plan for the proposed new export project. The CEO plans to take your recommendation to the December 2020 meeting of the company’s Board of Directors.
Your team has been working on the project for two months and has estimated that a new plant will cost $12.5 million to construct including specialist equipment purchased from a supplier in Italy for processing, packaging, and storage of produce to meet high standards required by potential clients in the Middle East, all of which can be depreciated on a straight-line basis over eight years for tax. In addition, at the end of the project’s life, estimated to be five-years, the plant and equipment could be scrapped for $3.2 million. There will also be a need to invest $500,000 in initial net working capital.
The project team has had discussions with the local council concerning the potential use of the land, and has been assured that building approvals would be quickly granted. Consequently, it is expected that construction of the plant could commence in February 2021 and be completed by the end of that year.
Based on research undertaken by the company’s marketing team and ZOOM meetings with potential clients in the Middle East, it is estimated that the company can sell $13 million of produce annually to clients in the region, the total capacity of the new plant, although this volume of export business will also require some air freighting through Melbourne Airport given the limits on available space on regular flights from Adelaide to the Middle East. Variable costs are estimated to be 50 per cent of sales, and fixed costs at $1 million a year.
The company’s CFO has informed the project team that the company will have to raise new capital to fund the investment in the project. The company’s current capital structure consists of the following:
Debt: 190,000 7.6% coupon unsecured notes with five years to maturity. These notes are currently priced at 98% of face value of $100, with half yearly coupon payments.
Equity: 5,000,000 ordinary shares outstanding currently selling for $3.72 per share. The company’s ordinary shares currently have a beta of 1.1, the market risk premium is 7%, and the risk-free rate is 3.5%.
The CFO has indicated that the company would use its investment bank to raise the capital required for the project, should it be approved, consistent with its current capital structure. Moreover, the company would not be able to allocate any retained earnings to the project as these funds are already committed to other projects. Subsequent discussions with the bank indicated that the costs and fees associated with raising new capital would be 7% on an issue of ordinary shares, and 4% on new debt issues.
The CFO considers that this export-based project is somewhat more risky than the typical domestic focused project undertaken by the company in the past. She has instructed you to use a risk adjustment factor of +5% in evaluating this project.
Based on all the information collected, you now need to develop a recommendation for the CEO, and draft a report for the Board of Directors to consider at its December meeting.
The company tax rate is 30%.
- Calculate the net present value and internal rate of return for the project. Would you recommend the project to the CEO?
- Briefly indicate any further analysis, if any, that you would recommend be undertaken before a final decision is made.
Assignment CASE 3
Surgical Robotics Ltd is a small Adelaide-based manufacturer of robotic surgical equipment incorporating research and development work undertaken by a research team at the University of Adelaide. The company has grown rapidly with wide adoption of its equipment in public hospitals and specialist clinics in Australia. This growth has been funded by retained earnings and two share issues, enabling the company to retain an all-equity capital structure since it was listed on the ASX.
At its last meeting the company’s directors discussed a proposal from the CFO to change the company’s capital structure to one with debt representing 30% of the value of the company. The directors, however, were not convinced that this would be in the best interests of long-term shareholders who had invested in the company partly on the basis of its business strategy and conservative financing policy.
The company currently has 1,000,000 shares outstanding, and the current market price is $5.00. EBIT is expected to be $4,000,000 and is forecast to remain stable indefinitely, given that future sales will largely be based on the purchase of replacement equipment. The interest rate on new debt is 7%. The company has just changed its dividend policy to one involving a payout rate of 100% that it plans to maintain indefinitely now its rapid growth phase is over.
Jessica Henderson is a shareholder and director of the company with a holding of 100,000 shares. She is unhappy with the decision of her fellow directors. She believes that the use of debt by the company would create value for its shareholders since debt is usually cheaper than equity capital. New debt capital raised by the company could be used to buy back its shares, and provide a cash return to shareholders who have supported the past growth of the company and elect to take up the buyback offer.
In order to boost her arguments in support of a change in capital structure, Jessica has sought your advice. She wants you to consider how she would benefit from the change in capital structure as an example to share with her fellow directors. You recall the Modigliani and Miller analysis from your time at university, and will use this as a guide to the advice you would provide to Jessica.
- As a first step, consider the impact of a change in the debt ratio of the company from 0 to 30% on Jessica’s annual income from her shares assuming the company is not subject to company tax. Assume that Jessica could invest any proceeds from re-purchase of her shares in an investment earning 7% per annum. What aspects of this analysis, if any, would you highlight in your report to Jessica?
- Now consider this change in capital structure in the context of the company being subject to company tax at the rate of 30%. What impact is this likely to have on Jessica’s income and the value of the company.?
- What other issues should you bring to Jessica’s attention in your report?