financial management

Swallowit is a small Australian pharmaceutical company. It is not fully integrated with the dividend imputation system.

As at 30th June 2012 it had prepared the following Balance Sheet

Assets
Accounts Receivable $ 125,000
Inventories $ 1,850,000
Property, Plant & Equipment $ 20,803,000
Prepayments $ 12,000
TOTAL ASSETS $ 22,790,000

Liabilities
Accounts Payable $ 90,000
Bank Overdraft $ 1,000,000
Accrued Revenue $ 25,000
Debentures $ 4,800,000
TOTAL LIABILITIES $ 5,915,000

NET ASSETS $ 16,875,000

Shareholders Equity
Preference Shares $ 2,000,000
Ordinary Shares $ 10,000,000
General Reserve $ 125,000
Retained Profit $ 4,750,000
TOTAL SHAREHOLDERS EQUITY $ 16,875,000
Notes

• The bank overdraft carries an annual percentage rate of 8% charged monthly.

• The debentures are currently trading at $309.29 each. Interest is paid half-yearly and they mature in 7 years time. They were originally issued with a face value of $300 with an annual coupon rate of 13.5%. Any new issues would incur flotation costs of $1.50 per debenture.

• The preference shares are currently trading at $8.10 each. They were originally issued in perpetuity at $8.00. Swallowit has just paid preference dividends totalling $275,000. Any new issues would incur flotation costs of $0.75 per share.

• Ordinary shares are currently trading at $1.75. There are currently 7,500,000 shares outstanding. Swallowit has just paid ordinary dividends totalling $1,125,000. Any new issues would incur flotation costs of $0.50 per share.

• Ordinary dividends over the preceding four years have been as follows

2007-08 $0.1189 per share
2008-09 $0.1276 per share
2009-10 $0.1373 per share
2010-11 $0.1462 per share
Ordinary dividends for 2011-12 have just been paid

• Swallowit has determined that the mix of debt, common stock, and preferred stock that was optimum was the one that the company presently employed. The proportions of this mix had been relatively stable over the past five years.

• Swallowit incorporates its Bank Overdraft in its calculation of The Weighted Average Cost of Capital.

• The company pays tax at a rate of 30%

1. Calculate the Company’s Weighted Average Cost of Capital

Swallowit has also asked its commercial bankers what the firm’s cost of various types of capital would be, assuming that the present capital structure is maintained. This yielded the following conclusions.

Debt

Up to $1 million of new debt the company can sell debentures at an interest rate of 14 percent. For additional funds above $1 million can issue debentures at an interest cost to the company of 16 percent.

Preferred Stock

Additional preferred stock in the amount of $1.5million can be sold at 14 percent. For additional raisings above $1.5 million this rate would increase by half of a percent.
Common Stock

Up to $4 million of new common can be sold at the current market price. Over $4 million of new common stock can be sold at $1.70 per share.

Management Initiatives

Initiative A

Management is considering a proposed construction of a new plant. Initially they are faced with the choice of either constructing a large or small plant. The expected life span of either construction is estimated to be 10 years. If a choice is made in favour of a small plant, management after three years will expand the small plant to achieve the same output of the large plant if such expansion is warranted.

Overhaul Costs are as follows

1. Calculate the Net Present Value and Internal Rate of Return for the three alternatives and advise management.
Initiative B

The general manager has proposed the purchase of one of two large induction distillers to replace its existing distiller. The key financial characteristics of the two proposed distillers are summarised below.

DISTILLER A

This can be purchased for $1,090,000. It will be depreciated under straight line using a four year recovery period. At the end of the four years the machine could be sold to net $380,000 before taxes. If this machine is acquired, it is anticipated that the following current account changes would result.

Cash + $25,400
Accounts Receivable + $70,000
Inventories – $40,000
Accounts Payable + $50,000

DISTILLER B

It costs $1,190,000. It will be depreciated using straight line using a five year recovery period. At the end of five years, it can be sold to net $330,000 before taxes. Acquisition of this press will have no effect on the company’s net working capital investment.

2. Calculate the Net Present Value and Internal Rate of Return for both Distillers
Management has detailed the following scenarios for sales, unit sales price, fixed costs and variable cost per unit for both distillers.

3. Prepare a sensitivity analysis of both distillers.

4. Which of the distillers is preferred? Why?

The company is considering the acquisition of robotic equipment that would radically change its manufacturing process.

• The robotic equipment would cost $3,500,000

• The equipment’s useful life is projected to be seven years, and 30 per cent diminishing value depreciation would be used for tax purposes.

• The robotic equipment requires software that will be developed over the first three years. However, the equipment would be fully functional from the beginning of the second year. Each software expenditure, which would amount to $75,000 per year, will be expensed during the year it is incurred.

• A computer systems operator would be hired immediately to oversee the operation of the new robotic equipment. The operator’s annual salary would be $86,000, plus on-costs of 40 per cent.

• Maintenance technicians would be needed. The total cost of their wages and on- costs would be $125,000 per year.

• The changeover of the manufacturing line would cost $180,000, to be fully expensed in the first year.

• Several of the company’s employees would need retraining to operate the new robotic equipment. The training costs are projected as follows:
First Year $35,000
Second Year $25,000
Third Year $10,000

• An inventory of spare parts for the robotic equipment would be purchased immediately at a cost of $60,000. This investment in working capital would be maintained throughout the life of the equipment. At the end the parts would be sold for $60,000.

• The robotic equipment’s salvage value is projected to be $75,000. It would be fully depreciated at that time.

• Apart from the costs specifically mentioned above, management expects that the robotic equipment would save $1,200,000 per year in manufacturing costs.

• Switching to the robotic equipment would enable the company to sell some of its manufacturing machinery over the next two years. The following sales schedule is projected:

5. Calculate the Net Present Value and Internal Rate of Return.
6. Assuming that Swallowit maintains this optimum market value capital structure, calculate the breaking points in the Marginal Cost of Capital (MCC) schedule.

7. Calculate Marginal cost of capital in the interval between each of the breaking points and graph the MCC schedule in its step function form.

8. Rank the preferred options within the initiatives according to both internal rates of return and profitability index.

9. Using the initial outlays graph your results against the MCC graph prepared above

10. Which initiatives should the company invest in

Assessment item 3
Assessment Item 3 (Topics 4 -7)
Value: 20%
Due date: 18-Sep-2016
Return date: 14-Oct-2016
Length: No more than 2000 words
Submission method options
Alternative submission method
Task
Question 1 (25 marks)

Home Guard has recently completed a $100,000, two-year study on its new pest control device. It can go into production for an initial investment in equipment of $5 million. The equipment will be depreciated straight line over the useful life of 5 years to a value of zero. The fully depreciated equipment is expected to sell for $800,000 at the end of its useful life. The project also requires investment in land value of $300,000 which is expected to have a realisable value of $500,000 at the end of the project. Investment of $400,000 in current assets will be recovered at the termination of the project.

The marketing department has estimated that 200,000 units of its new device could be sold annually over the next five years at a price of $7 each. Fixed costs of $500,000 per annum will be incurred. The firm is an ongoing profitable business and pays taxes at a 30% rate in the year of income. All capital gains will also be taxed at a rate of 30%. The company uses a 10% discount rate on the new project. Using the NPV approach, advise the firm whether the project should be undertaken.

Question 2 (25 marks)

Mega Resources Limited’s (MRL) is considering a major gold exploration project in South Africa. Costs of financing have been declining recently causing the finance department to consider sourcing capital through debt and equity issues. The company’s bonds will mature in five years with a total face value of $100 million, paying a half yearly coupon rate of 8% per annum. The yield on the bonds is 14% per annum. The market value for the company’s preference share is $4.75 per unit while the ordinary share is currently worth $1.85 per unit. The preference share pays a dividend of $0.4 per share. The beta coefficient for the ordinary share is 1.4. No issue costs will be incurred by the company.

The market risk premium is estimated to be 10% per annum and the risk-free rate is 4% per annum. The company is subject to a 30% corporate tax rate and intends to issue 200,000 preference shares and 5,000,000 ordinary shares. MRL’s current balance sheet shows the following information for bonds and shares:

$ (Million)
Preference shares
3
Ordinary shares
15
Bonds
100

a. Outline the necessary steps required to estimate the company’s weighted average cost of capital.(2 marks)

b. Calculate the after-tax cost of each of the company’s current financing sources.(7.5 marks)

c. Using the information provided, calculate the market values for the financing sources for MRL.(7.5 marks)

d. Using the information from b.) and c.) calculate MRL’s after-tax weighted average cost of capital.(5 marks)

e. The company’s finance department has confirmed that the proposed project will generate an IRR of 15% per year. Discuss whether or not the project should be undertaken. (3 marks)

Question 3 (20 marks, 10 marks each)

Write a short essay of 600-700 words for each of the following questions. You must support your discussion with appropriate references.

a. Discuss two reasons for a company offering credit terms to its customers.

b. “Cash is a very small percentage of total assets and therefore cash management is not an important part of financial management”. Critically discuss this statement

Rationale
This task will assess your ability to meet the following learning outcomes:

identify, analyse and solve financial problems confronting business enterprises, particularly problems relating to corporate investment, asset management and financing decisions;
employ analytical techniques, using contemporary electronic aids appropriate to financial decision making;
analyse the impact of economic, legal and tax changes on the financial position of the firm;
demonstrate critical evaluation and communication skills relating to the scope and all four learning outcomes of this subject

Marking criteria

Criteria
HD (85% – 100%)
DI (75% – 84%)
CR (65% – 74%)
PS ( 50% – 64%)
FL ( 0% – 49%)
Q1.Calculate the NPV of the project and provide a critical analysis of the proposed project.
Applies correct principles and calculations, substantiated with workings or diagrams in order to correctly calculate the NPV. There are no errors in calculations. Provides a precise critical analysis of the company’s proposed future.
Applies correct principles and calculations, substantiated with workings or diagrams in order to correctly calculate the NPV. Workings may contain s few minor errors. Provides a detailed critical analysis of the company’s proposed future.
Applies correct principles and calculations, substantiated with
workings or diagrams in order to correctly calculate the NPV. Workings contain some minor errors. Provides a critical analysis of the company’s proposed future. May contain limited detail and reference to examples from the case.
Applies understanding of relevant principles, correctly calculates the NPV. Workings contain some major errors. Attempts to provide a critical analysis of the company’s proposed future.
No understanding of relevant principles, incorrectly calculates the NPV. Workings contain major errors. Failed to provide a critical analysis of the company’s proposed future.
Q2. Complete calculation as required. Discuss your recommendations for the potential project and support with relevant calculations.
Applies correct principles and calculations, substantiated with workings or diagrams in order to arrive at the right answer. There are no errors in calculations.
Applies correct principles and calculations, substantiated with workings or diagrams in order to arrive at the right answer, shows workings but contains few minor errors.
Applies correct principles and calculations, substantiated with workings or diagrams in order to arrive at the right answer, shows workings but contains some minor errors.
Applies understanding of relevant principles, shows workings but contains some major errors.
No understanding of relevant principles, no workings and contains major errors.
Q3. Discuss the factors relevant to the company and illustrate with an appropriate example where possible.

Principles are applied in the appropriate manner to arrive at the correct answer. The use of relevant principles and example shows creativity and imagination.
Discussion reflects detailed understanding of relevant principles. Uses an example to illustrate the discussion.
Discussion reflects good understanding of relevant principles. Makes use of an example to attempt to illustrate but relevance is unclear or inaccurate.
Discussion reflects basic understanding of relevant principles. Limited or no use of relevant example.
Discussion reflects no understanding of relevant principles. No use of relevant example.
Academic Writing Skills
The discussion/ report/other meets academic standards of syntax, vocabulary, spelling and punctuation and reflects an awareness of audience needs
Accurate use of syntax, spelling and punctuation; correctly refers to an extensive variety of sources to support arguments, including prescribed texts and a broad range of additional readings; reference list of an extensive range of resources used, correctly formatted using APA style.
Accurate use of syntax, spelling and punctuation; succinct and effective use of vocabulary; correctly refers to a broad range of sources to support arguments, including prescribed text and a variety of further readings; reference lists a broad range of relevant resources used, correctly formatted using APA style.
Accurate use of syntax, vocabulary, spelling and punctuation; correctly refers to more than the minimum requirement of sources to support arguments, including prescribed texts and recommended readings; reference list formatted in APA style, with few or no errors.
Mostly accurate syntax, spelling and punctuation; correctly refers to minimum number of sources to support arguments, including prescribed texts; reference list used, formatted in APA style, with minor errors.
Inaccurate syntax, spelling and punctuation; incorrectly refers to minimum number of sources, including prescribed texts; reference list used, not formatted in APA style, with errors.

Presentation
Refer to the sections under Presentation and Submission for further details.

Requirements
This task requires the use of APA referencing. Please refer to the following website for further details: http://student.csu.edu.au/study/referencing-at-csu