The Evaluation of Oz-Seafoods Limited Capital Budgeting Projects - Assignment Example

? BANK 2007 Business Finance XXXXXXXXXX XXXXXXXXXX Question a: Specify whether the evaluation of Oz-seafoods Ltd’s capital budgeting projects should be undertaken on a pre-tax or after-tax basis. Answer: Oz-seafoods Limited is an Australian Stock Exchange listed company but 88 % of its ordinary shareholders are from the USA and Canada. Australian laws and taxation regulation there are two categories of companies. A shareholder, of a company, who benefits fully from dividend imputation, is classified as Category 1. Though, 88 % shareholders are not Australian citizen, but the company is registered on Australian Stock Exchange. This imposes limitation on the company to use Australian Tax though major shareholders are non-Australian. OZ – Seafood Limited, according to the Australian Tax law, is classified as Category 1 Company. Company’s capital budgeting projects should be undertaken on pre – tax basis, as recommended by the Australian Tax Regulation . Question b: Over how many years should Oz-seafoods’ capital budgeting evaluation of the polystyrene container manufacturing proposal be undertaken Answer: Machinery for manufacturing polystyrene containers has 10 years operational life with no salvage value. According to the Federal Laws, company can deprecate total cost of the machine on a straight-line basis over seven years. Capital budgeting evaluation should be undertaken over 7 years of time. However, that will give salvage value, which will be taxable. Question 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? Answer: I disagree. Working capital is project cash flow element. It has to be included in capital budgeting projects. Working capital in the cash flow model is considered to be an expense item. It is Tax-deductible. By including it, company benefits. At the end of the project, working capital is recovered and added to cash flow as a net earning. However, before adding it to the cash flow, its present value is evaluated. NPV is thus adjusted by adding the present value of working capital. Question 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 (ii) Value of Debt (iii) Cost of Equity (iv) Value of Equity (v) Weighted Average Cost of Capital. Round your calculated answer to the nearest whole percentage (i) Cost of Debt calculation. Oz – seafoods has 5$ million current debt and 20 $ million long-term debts. The company should consider only long term debt for its investment projects. Cost of these bonds in the project is the rate of return has to be paid to the bond owners. This rate of return is named as Yield for the bond owners, and is the cost of debt for the company. The effective yield is calculated using the formula (Investing Answers): [1+ (r/n)] ^ n – 1; where: r = Normal rate n = number of payment in one year Long term bonds = 20 $ million Average maturity= 10 years. Average coupon rate, r = 10.7 % per annum , Number of payment in one year, (paid half yearly), n = 2 r/n = 0.107 / 2 = 0.0535 (1+0.0535)^2 – 1 = 0.10986 FV = 20,000,000 $ Coupon rate = 10.7 % Coupon PMT = 1,070,000 $ half yearly COMP i = 10.986 % = 11 % = 11 % Oz – seafoods’ economist has predicted an estimated 2 % inflation rate. With this adjustment, k D = 13 % The relationship between real rate and nominal rate is (Fisher formula):  Rn = (1 + Rr)(1 + Ri) - 1 = Rr+ Ri+ RrRi (Nominal rate / Real rate calculator – Web.) Where, Rn is nominal rate, Rr is real rate and Ri is inflation rate. k D = k D = 0.02 + 0.11+ 0.11 * 0.02 = 0.1322 = 13.22 % = 13 % Note: 1. The current Yield rate on similar bonds is 9 % per annum. This is 6 % per annum above the government bonds with the same maturity. OZ – seafoods’ economist has predicted an average 7 % p.a. return above the government securities. The calculated value k D = 13 % consider this increase. 2. Oz – seafoods , according to the Australian Tax category belongs to Category 1. Cost of Debt is calculated before Corporate Tax (ii) Value of debt: Debt capital is incurred by issuing bonds in the market. Bonds’ market value is a discounted value. The project doesn’t specify bonds discount value. In this case market value of debt is calculated considering entire debt as one coupon bond, with a coupon set equal to the interest on all debt and the maturity set equal to the face-value weighted average maturity of the debt, and then to value this coupon bond at the current cost of debt for the company (Estimating market value of debt – Web.) It is a conservative approach. OZ – seafoods may use more flexible approach. Formula for value of debt evaluation: 1 1- ------------ (1+ k D) ^ N PV Market value = PMT [--------------------- ] + -------------- k D (1+ k D) ^ N PMT = 1,070,000 $, Yearly payment PV = 20,000,000 $, Value of bond N = 10, Years maturity k D = 13 %, Cost of Bond Calculation: (1+ k D) = 1 + 0.13 = 1.13 (1+ k D) ^ N = (1.13) ^ 10 = 3.40 1/(1+ k D) ^ N = 1 / 3.40 = 0.295 1- 1/(1+ k D) ^ N = 1 – 0.295 = 0.705 1- 1/(1+ k D) ^ N / k D = 5.426 PMT x 1- 1/(1+ k D) ^ N / k D = 5,806,081 PV / (1+ k D) ^ N = 5,891,767 Market value = 5,806,081 + 5,891,767 = 11,697,847 $ This value was compared with the Investopedia.com on line bond valuation calculator. Result is shown below (Bond Price – Web.). A bond settling on 5/12/2012 with a par value of 20,000,000.00, a maturity date of 5/12/2022, a coupon rate of 10.07, and a market yield of 13.00 will be priced at $11,101,312.74. (This is with a redemption value of $20,000.00, which is typically the same as par value.) Price: $11,101,312.74 (iii) Cost of ordinary Equity: The company can use two different equities; (1) Ordinary Shares, (2) Retained Earnings Ordinary Shares = 10,000,000 $ Retained Earnings = 5,000,000 $ (a) Cost of ordinary share in capital budgeting (Definition of “Cost of equity” – Web.) Current ordinary share price : 1.80 $ Dividend per share : 0.16 $ Growth = 5 % r E, AT = k E , AT = (0.16/1.8) + 0.05 = 13.8 % = 14 % Long-term inflation rate predicted: 2 % The relationship between real rate and nominal rate is (Fisher formula):  Rn = (1 + Rr)(1 + Ri) - 1 = Rr+ Ri+ RrRi (Nominal rate / Real rate calculator – Web.) Adjusted rate r E, AT = 16 % (b) Cost of Retained Earning in capital budgeting We consider: 1. The current yield on company debt similar rating 9 % per annum, which is 6 % per annum above the yield of government bonds of similar maturity 2. Market portfolio will on average provide a return of 7 % above government securities. 3. 2 % long term rate of inflation We use Capital Asset Pricing Model or CAPM to for equity value calculation. The formula: r E = r f + [ (r M – r f) ? ] Where: R f = Risk free government bond rate R M = Historical return from a market portfolio ? = Historical beta for the company r f = 3 % r m = 10 % ? = 1.74 r E = 0.03 + [ (0.1- 0.03) * 1.74 ] = 0.15 = 15 % With inflation adjustment r E = 17 % Thus, Adjusted rate r E, AT of ordinary shares = 16 % Adjusted rate r E, AT of retained earning = 17 % Accepted r E = 17 % (iv) Value of equity: All shares are considered outstanding. Therefore, Market Capitalization is equal to 15,000,000 $. Value of equity is 10,000,000 $ + 5,000,000 $ = 15,000,000 $ Market values: Bond = 11,697,847 $ = 12 M $ Equity =15,000,000 $ = 15 M $ Total = 27 M $ (v) Weighted Average Cost of Capital or “WACC” (Investopedia explains 'Weighted Average Cost Of Capital - WACC' - Web) Note: for OZ – seafoods, WACC is evaluated before Tax; Considering Category 1 company We have; Cost of debt, k D = 13 % Cost of equity, k E = 17 % Value of debt = 12 M $ Value of equity = 15 M $ Total value , V = 27 M $ Corporate Tax, Tc = 30 % WACC = (E/V) * k E + (D/V) * k D WACC = (27/15) * 0.17 + (27/12) * 0.13 = 0.56 * 0.17 + 0.44 * 0.13 = 15 % Weighted Average Cost of Capital = 15 % Question e: Evaluate the capital budgeting project to manufacture polystyrene containers: i) Calculate the company’s initial outlay. ii) Using 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. iii) Calculate the company’s terminal cash flows iv) Draw a cash-flow diagram / timeline detailing the incremental net cash flows for each time period for the polystyrene container manufacturing project. Cost of manufacturing machine: 150,000 $ Working capital: 30,000 $ Depreciation: Linear 7 years Quantity: 200,000 pieces Price per piece: 1.50 $ RRR = 15 % Corporate Tax = 30 % Assumptions: 1. Polystyrene container manufacturing is considered as an independent project 2. All production expenses are embedded in working capital 3. Table 1. Initial outlay, operating and terminal cash flow Yr 0 1 2 3 4 5 6 7 No of containers 200,000 200,000 200,000 200,000 200,000 200,000 200,000 Price of 1 container $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50 Total Sales $ 300,000 $ 300,000 $ 300,000 $ 300,000 $ 300,000 $ 300,000 $ 300,000 Working capital $ (30,000) $ (30,000) $ (30,000) $ (30,000) $ (30,000) $ (30,000) $ (30,000) Depreciation $ (21,429) $ (21,429) $ (21,429) $ (21,429) $ (21,429) $ (21,429) $ (21,429) Salvage $ 45,000 Profit B/T $ 248,571 $ 248,571 $ 248,571 $ 248,571 $ 248,571 $ 248,571 $ 293,571 Tax @ 30 % $ 74,571 $ 74,571 $ 74,571 $ 74,571 $ 74,571 $ 74,571 $ 88,071 Profit A/T $ 174,000 $ 174,000 $ 174,000 $ 174,000 $ 174,000 $ 174,000 $ 205,500 Add back depreciation $ 21,429 $ 21,429 $ 21,429 $ 21,429 $ 21,429 $ 21,429 $ 21,429 WC recovery $ 11,989 Operating CF $ 195,429 $ 195,429 $ 195,429 $ 195,429 $ 195,429 $ 195,429 $ 238,918 Machine purchase $(150,000) Net cash flow $(150,000) $ 195,429 $ 195,429 $ 195,429 $ 195,429 $ 195,429 $ 195,429 $ 238,918 Table 1. Initial outlay, operating and terminal cash flow Notes: 1. Machine cost depreciation 7 years. Depreciation values 150,000 / 7 = 21,429 $ 2. Machine life is 10 years with zero salvage value. Each year’s depreciation is 150,000 / 10 = 15,000 $. After 7 years machine will have a salvage value 15,000 x 3 = 45,000 $ . This value is added in the terminal year as an earning. Time value factor is not is not calculated. It is considered time value factor of cost of machine is embedded in machine life. 3. Working capital is an expense. It is added as an expense for years from 1- 6. Working capital is recovered in the terminal year. It is added as an income after tax. Time value factor is considered for Net Working Capital adjustment. Recovery: 30,000 FV, 7 n , 14 I (I/Y). COMP : 11,989 $ 4. In Terminal cash flow, salvage is added as income before tax 5. In Terminal cash flow , recovered working capital is added as income after tax. So, it is considered in NPV calculation i) Calculate the company’s initial outlay Initial outlay, Io = 150,000 $ ii) Using the worksheet set out the amount and timing of all the relevant incremental (differential) operating net cash flows for each year of the project. Table 1 shows relevant increment and decrement per each year iii) Calculate the company’s terminal cash flows (ignoring any annual operating cash flow amounts) Table 1 shows company’s seven-year cash flow. Shown below cash flow of the terminal year without considering operating cash flow amount. Year 7 – Terminal year No. of containers 200,0000 Cost of 1 container 1.50 $ Total sales 300,000 $ Working capital (30,000) $ Depreciation (21,429) $ Salvage 45,000 $ Profit B/T 293,571 $ Tax @ 30 % 88,071 $ Add back depreciation 21,429 WC recovery 11,989 Note: Time value factor is considered for Net Working Capital adjustment. Recovery: 30,000 FV, 7 n , 14 I (I/Y). COMP : 11,989 $ iv) Draw a cash-flow diagram / timeline detailing the incremental net cash flows for each time period for the polystyrene container manufacturing project. Value ($) + Positive Cash inflow 238.919 195.429; 195.429; 195.429;195.429;195.429;195.429 Time (Year) 0 1 2 3 4 5 6 7 (150,000) Initial Lay Negative Note: Graph not scaled f) Calculate the net present value of the polystyrene container manufacturing project. NPV calculation: @ RRR = 15 % (From WACC calculation) Cash flow values are from Table 1. Cash inflow PV @ 15 % Initial Cash outlay -150,000 Year 1 195,429 169,938 Year 2 195,429 147,772 Year 3 195,429 128,498 Year 4 195,429 111,737 Year 5 195,429 97,163 Year 6 195,429 84,489 Year 7 195,429 89,818 829,416 Initial cash outlay - 150,000 Net present value (NPV) 679,416 (g) What is recommendation about proceeding with the polystyrene container manufacturing project Answer: Polystyrene container manufacturing project is economically feasibly. NPV calculation shows project can pay for initial lay and make a profit of 679,416 $. Question 2: Gino and Mario are two brothers who have recently entered into a partnership together to establish a pasta manufacturing and retail business. They are currently in the process of evaluating two models of pasta making machine for installation in their 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 each pasta 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. b) (i) Based only on your NPV calculations above, recommend to the brothers which pasta making machine they should purchase? Briefly justify your response. ii) Briefly discuss if there is a problem with this recommendation. c) Using the Equivalent Annual Annuity method determine and recommend which machine the brothers should purchase. a) For each pasta-making machine, draw a time line identifying its cash flows and calculate the net present value to purchase the machine. Machine A Initial outlay -70,500 $ Yr 1 13,750 $ Yr 2 6,250 $ Yr 3 13,750 $ Yr 4 6,250 $ Yr 5 13,750 $ Yr 6 6,250 $ Yr 7 13,750 $ Yr 8 13,750 $ Time line cash flow diagram Value ($) Cash inflow 13,750 13,750 13,750 13,750 13,750 6,250 6,250 6,250 Time (Years) 1 2 3 4 5 6 7 8 -70,500 $ (Initial lay) Note: Graph not scaled Machine B Initial outlay -100,000 $ Yr 1 10,000 $ Yr 2 3,000 $ Yr 3 10,000 $ Yr 4 3,000 $ Yr 5 10,000 $ Yr 6 3,000 $ Yr 7 10,000 $ Yr 8 10,000 $ Time line Cash flow diagram Value ($) Cash inflow 10,000 10,000 10,000 10,000 10,000 10,000 10,000 3,000 3,000 3,000 3,000 Time (Years) 1 2 3 4 5 6 7 8 9 10 -70,500 $ (Initial lay) Note: Graph not scaled b) Based on NPV calculations recommend to the brothers which pasta making machine they should purchase NPV Calculation RRR = 12 % per annum Machine A Machine B Initial Outlay -70,500 $ Initial outlay - 100,000 $ Cash inflow PV @ 12 % Cash inflow PV @ 12 % YR 1 13,750 12,277 YR1 10,000 8,929 YR 2 6,250 4,982 YR2 3,000 2,392 YR 3 13,750 9,787 YR3 10,000 7,118 YR 4 6,250 3,972 YR4 3,000 1,907 YR 5 13,750 7,802 YR5 10,000 5,674 YR 6 6,250 3,166 YR6 3,000 1,520 YR 7 13,750 6,220 YR7 10,000 4,523 YR 8 13,750 5,553 YR8 3,000 1,212 YR 9 53,760 YR9 10,000 3,606 YR 10 YR10 10,000 3,220 40,100 Net Present Values of cash inflows. Machine A Machine B PV Value 53,760 40,100 Initial outlay -70,500 -100,000 NPV - 16,740 - 59,900 ii) Briefly discuss if there is a problem with this recommendation. (i) NPV calculation for Machine A and Machine B shows that in both cases they are negative. If NPV < 0, project must be rejected. In both cases it shows that the business will not be able repay the initial outlay. In both options it is high investment and low cash inflow. Recommendation: Reject both options. (ii) There is no problem with this recommendation. The recommendation follows the capital budgeting methods and guidance. c) Using the Equivalent Annual Annuity method determine and recommend which machine the brothers should purchase. EAA is calculated using formula, (Equivalent Annual Annuity – Web.) r(NPV) C = ------------------------- 1 – (1+r) - n C = Equivalent equity cash flow NPV = Net present value r = rate per period n = number of periods Machine A Machine B NPV = - 16,740 NPV = - 59,900 EAA = - 3, 370 EAA = - 10,701 Recommendation: Project with Machine A will loose every month 3,370 $ . Project with Machine B will loose every month 10,701 $. This project economically is not feasible. 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