MGSM835 FINANCIAL MANAGEMENT
INDIVIDUAL ASSIGNMENT
Term 4, 2012
This is an individual assessment item. As such, you should not share your work with others or work in syndicate on this assignment. You should clearly set out your assumptions, and show all workings. Do not submit just spreadsheets, other than as attachments to support your answers.
Question 1(20%)
You have been presented with data projections for the Belligerent City Tunnel, a dual-carriage road tunnel that will pass under the central business district of Sydney.
The tunnel will take three years to build. An immediate cash outlay of $220 million will be required, followed by further investments of $ 80 million at the end of year one, $20 million at the end of year two and $10 million at the end of year three. The tunnel will become operational at the beginning of year four, and over years four and five, 90,000 vehicles are expected to travel through the tunnel each day. Management and maintenance expenses associated with the tunnel will be $10 million before-tax in each of years four and five. From year five onwards, the after-tax cash flow generated by the project is expected to grow at a constant annual rate of 3% per year, into perpetuity. There is no depreciation on the outlays incurred over the construction phase of the project. The operators expect the toll to be $3.00 per vehicle, irrespective of the size or type of vehicle. The after-tax required rate of return on the project is 15% per annum.
Assume revenue and expenses occur at the end of each year. Taxes apply to profits earned in year four and beyond, and the relevant tax rate is 30%. Inflation is expected to be zero all projections, growth rates and discount rates are expressed in real terms. The tunnel is expected to be operational 365 days per year.
Required
a) What is the net present value of the tunnel project? Should the project proceed?
b) Suppose you believe a more realistic projection is 60,000 vehicles per day. What is the impact on the net present value of the proposed project?
c) Given your answer to (b), what is the minimum toll per vehicle that would need to be charged to ensure investors earn their required return?
Question 2 (30%)
The following information is assembled regarding a potential project.
1. The project requires an initial investment in equipment of $80 million. The equipment has an eight-year life for depreciation purposes and can be depreciated on a straight-line basis to a zero book value.
2. The project has an investment horizon of five years.
3. Following consultation with experts it is envisaged that the equipment can be sold at the end of five years for $35 million.
4. The project is expected to generate direct cash benefits of $15 million per year on a before-tax basis. This excludes labour savings.
5. The project is also expected to enable processes to be streamlined in an unrelated business unit. The cost savings would be $5 million per year before-tax.
6. The direct labour cost in the unit is $6 million per year, and following installation of the equipment, this is expected to fall to $2 million per year. This embodies employees who will not have contracts renewed.
7. Head office costs are allocated to business units on the basis of direct labour costs. The reduction in labour costs to the division implies that overheads allocated to the unit will be reduced by $8 million per year.
8. Specialist technicians will be needed to support the project. The firm will redeploy technicians from elsewhere in the firm, and they will not be replaced. These technicians currently cost $2 million per year in pre-tax labour costs, and these costs are not expected to change. The technicians currently contribute $1 million per year in total to before-tax profits of the firm.
9. The project will require an increase in net working capital of $10 million at commencement. This will increase to $11 million at the end of the first year and $12 million by the end of the second year. It will remain stable at $12 million over the remainder of the project. All incremental investments in working capital are recoverable.
10. The project will be housed in a facility that is currently unoccupied and which is expected to remain so in the near future. The market value of the land on which the facility is housed is $7 million.
11. In order to get to the current stage, the firm has incurred research and development costs of $2 million on an after-tax basis. These are directly related to the project.
12. Investors require a return on this project of 13% before company taxes are paid.
13. The company tax rate is 30% and taxes are paid as soon as any tax liability is incurred. The firm is making profits from other sources.
14. Inflation is expected to be zero.
Required
Treat each question independently, meaning changes apply only to the initial data for the project set out above.
a) What is the net present value of the project? Should the proposal proceed?
b) Suppose depreciation can be accelerated at a rate equal to 1.5 times the current rate. What is the impact on the net present value of the proposal? What is the impact on the profits of the proposal?
c) Suppose a consultant argues that the market value of the equipment is likely to be $25 million after five years. What is the impact on the proposal?
d) Management are pondering whether or not the technicians should be replaced. Should the specialist technicians that are transferred to the project be replaced with new technicians in the areas from which they came? What is the impact on the project?
e) Investigations reveal that the equipment can be leased for an annual payment of $16.5 million, payable in advance. The lease payment is deductible for tax purposes. The lease is non-cancellable and there is no purchase option at the end of the five year lease.
f) Should you be able to negotiate on the lease payment, what is the maximum lease payment that you would be prepared to pay?
Question 3 (30%)
The following information is assembled regarding a potential project.
1. The project requires an initial investment in equipment of $1 million. The equipment has a five-year life for depreciation purposes and can be depreciated on a straight-line basis to a zero book value. The equipment has no salvage value.
2. The project has an investment horizon of five years.
3. The project requires supporting net working capital equal to 10% of revenue. All incremental working capital investments are recovered at the end of the project investment horizon.
4. Revenue is a function of the size of the market, the market share of the firm, and the expected price of the product. The market is expected to sustain 200,000 units per year, market share is expected to be 25%, and the product should be priced at $50 per unit.
5. Direct costs are expected to be $40 per unit, and fixed cash costs $65,128 per annum.
6. The real required rate of return on the investment is 10% after-tax. The company tax rate is 30% and taxes are paid as soon as any tax liability is incurred. The firm is making profits from other sources.
7. Inflation is initially expected to be zero. Assume all revenue, costs and balance sheet items are expressed in real terms.
Required
Treat each question independently, meaning changes apply only to the initial figures for the project set out above.
a) What is the net present value of the project? Should the proposal proceed?
b) What would be the impact on the value of the project if inflation is expected to be 6% per annum?
c) What would be the impact on the value of the project if management expect competition to impact such that the selling price of the product will fall by 5% per year, while productivity improvements should allow direct costs to fall by 3% per year? Assume inflation is expected to be zero and working capital requirements are equal to 10% of revenues.
d) At what level can market share for the product fall to before the project should be rejected?
e) Suppose some managers expect that the project will require working capital equal to 20% of revenues. What is the impact on the value of the project?
f) Suppose it is determined that a reduction in credit terms to customers will result in working capital falling to 2% of revenues, while the market share of the product would concurrently decline from 25% to 24% due to lost customers under the revised credit terms. Would it be a good decision for the firm to reduce its credit terms? Explain.
Question 4 (20%)
You are required to select one project out of three alternatives, where each alternative involves an investment that produces a specific cash flow profile. Details of each project are as follows (all figures are expressed on a before-tax basis):
Project A
Equipment outlay $50 million
Project life 4 years
Equipment life 4 years
Depreciation Straight-line over 4 years to zero book value
Salvage value at end of project $10 million
Cash revenue $27 million per year
Cash expenses $8 million per year
Project B
Equipment outlay $50 million
Project life 4 years
Equipment life 4 years
Depreciation Straight-line over 4 years to zero book value
Salvage value at end of project $0
Cash revenue $31.3 million in year one, declining by 10% per year
Cash expenses $6 million per year
Project C
Equipment outlay $55 million
Project life 4 years
Equipment life 6 years
Depreciation Straight-line over 6 years to zero book value
Salvage value at end of project $11 million
Cash revenue $31 million per year
Cash expenses $6 million per year
The required rate of return on each project is 15% after-tax. The corporate tax rate is 30% and taxes are paid as soon as any tax liability is incurred. The firm is earning profits from other sources. Inflation is expected to be zero.
Some managers believe the project that generates the highest average profits should be selected. Others recommend that the project that generates the highest average return on assets (ROA) should be selected, given their bonus is linked to ROA.1 Rudolph Rambunctious, a recent MBA graduate, argues that the bonus scheme is flawed because it potentially encourages managers to select the wrong projects.
Required
a) Which project should be selected according to average profits?
b) Which project should be selected according to average ROA?
c) Which project creates the greatest value to shareholders? Is Rudolph correct? Explain.
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1 Note that average ROA corresponds to the average accounting rate of return.