ACC515 2019 30

Assignment 2

Part A (50 Marks)

Background:

This case is fictional and bears no relation to actual practice at Mars Australia New Zealand

Mars Australia and New Zealand manufacture a range of fast moving consumer goods

(FMCG) including pet food and pet care products, chocolates, confectionery, ice cream, and a

variety of food products and supplements. These products are largely sold through

supermarkets and specialty retailers. The Head Office for Mars Australia is in Albury

Wodonga on the New South Wales – Victorian border. The company opened its first

manufacturing facility in Albury Wodonga in 1966. Since then they have expanded their

manufacturing footprint to include other sites in regional Australia and New Zealand.

In the past two years Mars have launched their ‘Sustainable in a Generation’ plan which

reflects their plan to “grow in ways that are good for people, good for the planet, and good for

our business” (Mars, 2019: https://www.mars.com/global/sustainable-in-a-generation). A key

focus to achieve these a goals is to focus on more efficient use of water and energy resources.

Mars has a large confectionery factory in Ballarat which first opened 40 years ago in 1979.

Confectionery manufactured in Ballarat includes the eponymous Mars Bar, Snickers,

Maltesers, M&Ms, Bounty and Dove chocolates. The factory that manufactures the ‘Nutty

Nut’ chocolate bar has not undergone a major refurbishment in the past 20 years and product

managers are concerned that the cost of operating and maintaining old technology has

impacted the cost and quality of the product.

Problem:

A full product market research analysis of the ‘Nutty Nut’ brand has been undertaken by

external consultants at a cost of $500,000. The consultants found that by improving the

quality of the product and lowering the cost, Nutty Nut can potentially become a market

leader.

Facilities management have produced the following budget on a factory refurbishment and

technology upgrade which will cost an initial capital outlay of AUD$17.5 million. The

existing plant and equipment will be sold for salvage and is expected to have a salvage value

of $400,000. The existing equipment has a zero written down value in the accounts having

been fully depreciated over its life. The upgraded facility will be ready for use at the

commencement of the 2019-20 financial year. The upgrade will result in a 20% cut in power

usage which represents a saving in electricity costs of $25,000 per week and an annual saving

of $600,000 in water costs. The use of advanced robotics mean that less direct labour is

required and labour savings and on-costs will amount to $2.5 million per annum. It is

estimated that the cost of training staff to operate the new production line will amount to

$750,000 which will be incurred before the new facilities come on-line. This cost is expected

to be recorded as labour costs in the 2019 financial year. Extra maintenance of the new

information technology (IT) and robotics is estimated to cost approximately $4,000 per week.

The new production facility will be depreciated on a straight line basis over its 10 year

lifecycle to zero. Because of anticipated technology changes the production facility is

expected to have a salvage value of $1 million at the end of 10 years. Mars are an

international company and pay Australian tax at the rate of 30% on profits. The capital

budgeting analysis should be conducted on an after tax basis. For the purpose of this analysis,

tax should be recognised in the same year as the cash flow generating activity.

The upgrade will increase the production capacity of the original factory by 50% and all costs

other than Raw Materials will now be fixed. Whilst the proposed refurbished facility will

achieve many facets of the Mars sustainability agenda the project must still pass the

company’s international benchmark for capital investment of achieving a return of 20%.

Prepare an excel spreadsheet calculating whether this product will satisfy the investment

parameters set by Mars.

(i) Prepare an excel spreadsheet calculating whether this product will satisfy the

investment parameters set by Mars. For the proposed ‘Nutty Nut’ capital

investment calculate the following:

o After-tax cash flows (15 marks)

o Payback period (3 marks)

o Net present value (5 marks)

o Profitability index (2 marks)

(ii) You are asked to present a report on your findings regarding the upgrade proposal.

Make a recommendation to Management on whether they should proceed with the

upgrade or not. Explain the criteria on which you have based your decision and

ensure that you include an analysis of the strategic implications of some of the

cost assumptions which underpin the budget. (10 marks)

(iii) The closure of a Mars product line at their Ballarat site has left the company with

an unoccupied manufacturing facility. Two projects have been proposed to use

the space and the following estimates of the present value of the competing

project cash flows have been made:

Chocolate Ice-cream

Net Present Value $25,000 $32,000

Estimated useful life 6 years 9 years

a) Explain how financial managers may evaluate two mutually exclusive

projects that are of unequal lives. (10 marks)

b) Assuming a required rate of return on projects of this type is 12% decide

which project you think the company should accept (show all workings)? (5 marks)

Part B (50 Marks) Cost of Capital

Cloudstreet Ltd is an Australian firm which is publicly-listed on the ASX. The company has a

long term target capital structure of 60% Ordinary Equity, 10% Preference Shares, and 30%

Debt. All of the shareholders of Cloudstreet are Australian residents for tax purposes. To

fund a major expansion Cloudstreet Ltd needs to raise a $120 million in capital from debt

and equity markets.

Cloudstreet Ltd’s broker advises that they can sell new corporate bonds to investors for

$1030 with a coupon of 6% and a face value of $1,000. Issue costs on this new debt is

expected to be 1.5% of face value. The bonds will mature in six (6) years. The firm can also

issue new $100 preference shares which will pay a dividend of $8 and have issue costs of

5%. The company also plans to issue new Ordinary Shares at an issue cost of 3%. The

ordinary shares of Cloudstreet are currently trading at $7.50 per share and will pay a

dividend of $0.40 this year. Ordinary dividends in Cloudstreet are predicted to grow at a

constant rate of 4% pa.

a. (i) Calculate how much debt Cloudstreet will need to issue to maintain their

target capital structure. (2 marks)

(ii). What will be the appropriate cost of debt for Cloudstreet? (8 marks)

b. (i) Calculate how much Preference Share equity Cloudstreet will need to issue to

maintain their target capital structure. (2 marks)

(ii). What will be the appropriate cost of Preference shares for Cloudstreet? (8 marks)

c. (i) Calculate how much Ordinary Share equity Cloudstreet will need to issue to

maintain their target capital structure. (2 marks)

(ii). What will be the appropriate cost of Ordinary Equity shares for Cloudstreet? (8 marks)

d. Calculate the Weighted Average Cost of Capital for Cloudstreet following the new

capital raising. (10 marks)

e. Cloudstreet Ltd has a current EBIT of $1.5 million per annum. The CFO approaches

the Board and advises them that they have devised a strategy which will lower the

company’s cost of capital by a full 1%. How will this change the value of the company?

Support your answer using theory and calculations. (10 marks)

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Sample Answers

Assignment 2

By (Name)

Course

Professor

University

Physical Address

Date

Part A

I. Excel spreadsheet attached.

II. Findings and Recommendations

The project has a negative net present value of $3,925,248.24, a profitability index of 0.13, and a payback period of 5.40, as shown in the table below.

Payback period 5.40 years

Net present value ($3,925,248.24)

Profitability Index 0.13

Figure 1: Summary results of the payback period, profitability index and net present value

Decision criteria

Mars should not invest in the project since it has a low net present value, low profitability index, as well as a long payback period.

Payback period

The payback period refers to the amount of time a company takes to recover its initial investment in a project. The payback period is estimated by establishing cumulative cash flows as well as determining the period in which the company will recover its initial costs.

The payback period is slightly high as the company will have to recoup its initial costs in five years and 40 days. Therefore, this shows that Mars will take more time to clear its initial costs to allow the company to generate more cash flows. Also, the initial outlay is high, leading to a higher payback period. Thus, Mars should not invest in the project.

Net present value

Net present value compares the future value of cash flows as with the initial capital outlay of a project to identify which is the most profitable for the company. Consequently, in this case, the net present value is negative (-$3,925,248.24, which means the project cannot be accepted. Only projects with a positive net present value are considered for investment in a company. Moreover, this shows that the company has high costs, which would result in the reduced net present value of the firm. Therefore, Mars should not invest in the project.

Profitability Index

Profitability index appraises a project by dividing the present value of future cash flows with the initial investment for a particular project. The profitability index for this project is estimated at 0.13. This profitability index is very low, which means the firm will generate low cash flows from the project. Only projects with higher profitability index should be accepted in an investment appraisal. Therefore, Mars should not invest in the project as a result of low profitability index.

Strategic implications of costs

Investment into the projects leads to an increase in the costs of the company. Despite the cost savings in labour, energy, and water, there are additional costs which are incurred weekly as a result of the maintenance of the new information technology and robotics of the company. These costs are incurred weekly, which leads to an increase in the fixed costs of the company. Also, treating all costs as fixed costs make it difficult to estimate the total overheads in every production unit of the company.

However, the desire to invest in the project increases the company’s ability to save on energy and water costs helps in the attainability of the company’s environmental sustainability. The company seeks to achieve sustainability by minimising the production costs, which makes it easier for them to ensure proper utilisation of the environment as well as environmental reporting. Therefore, all these will help the company to improve sustainability, but the company cannot invest in the project since its net present value is low and leads to increased costs.

III. Ballarat Site

a. How Managers Evaluate Two Mutually Exclusive Projects with Unequal Lives

Mutually exclusive projects with unequal life span are evaluated using annual net present value and replacement chain method (Shu et al., 2016, pg.240). Annual net present value involves the estimation of the adjusted net present value of project life. This is obtained by dividing the net present value of each project with the annuity discount factor for the project life. The project with the highest annual net present value should be accepted.

Annual net Present Value = (Net Present Value/Annuity Discount Factor for the Project Life)

According to the replacement chain method, cash flows are repeated for a common least useful life, for example, if one project has three years and the other 5years the least common useful life is 15 years. After this, a project with a high net present value and internal rate of return is accepted.

Therefore, these methods will show the project in which a company would invest in. In most cases, the project with a high annual net present value and the project with the highest net present value for the least common useful life.

b.

To identify the best project, the analysis uses annual net present value method since the net present values of each product have been provided.

Annuity discount factor NPV Annual NPV

Project 1 PVIAF12%6years $ 25,000.00 $ 12,665.78

Project 2 PVIAF12%9years $ 32,000.00 $ 11,539.52

Figure 2: Estimation of annual net present value

The company needs to select the project with a useful life of 6years since the project has a higher net present value.

Part B.

a. Debt

i.) Total debt

The total debt in Cloudstreet Ltd accounts for 30% of the total capital investment the company requires.

30%*120000000= 36000000

ii.) Cost of debt

The cost of debt is estimated using the yield to maturity formula where the present value and future value of the debt is considered in the estimation of the cost of debt. The cost of debt represents the interest Cloudstreet Ltd will pay on the $1030 coupon bonds. The value was estimated through excel, and the results are as follows.

Face value 1030 Future value $ 1,030.00

Price 1000 Present value $ (985.00)

Issuance costs 1.50% $15 to be deducted from the total price.

maturity 6 nper 6

Coupon 6% PMT $ 61.80

Yield 6.91%

Figure 3: Estimation of the cost of debt

The yield to maturity will be used as the cost of debt for Cloudstreet Ltd.

b. Preference shares

The preference shares account for 10% of the total initial capital outlay required to start the project by Cloudstreet Ltd.

i. Total preference shares

10%*$120,000,000= $36,000,000

ii. Cost of preference shares

= annual dividend/ (market price-issuance cost)*100

=$8/ (100- (5%*$100)

= 8.42%

c. Ordinary shares

The ordinary shares of Cloudstreet Ltd are 60% of the total initial capital outlay required.

i. Total ordinary shares

60%*$120,000,000 = $72,000,000

ii. Cost of equity shares

Dividend growth model

The dividend growth model uses the current share price, the dividend paid, and the rate of dividend growth in the estimation of the cost of equity (Kung and Schmid, 2015, pg.1001). Dividends increase at a constant rate in this model, therefore, leading to the change in the value of ordinary shares. The current price of the stocks is $7.5, and the dividends on the shares are $0.04 per share while the dividend growth is 4%. The cost of ordinary shares is estimated as follows.

Po= Do/ (Ke-g)

Ke = (Do/Po) +g

Issuance cost= 3% of $7.5=$0.0225

Po= (0.04/ (7.5-0.0225)) +4%

Po= 4.5%

d. Weighted Average Cost of Capital

WACC= Weight of ordinary shares*cost of ordinary shares + weight of preference shares*cost of preference shares+ weight of debt*cost of debt (1-Tc)

= (0.6*4.5%) + (0.1*8.42%) + (0.3*6.91%)

= 6%

e. Reduction in cost of capital

Capital Structure Theories

Net Income Approach

Nevertheless, even though the firm intends to reduce the cost of capital to improve its incomes by lowering the cost of capital, there is a need to consider the impact on investment. However, the reduction in the cost of capital will result in higher incomes, which can be invested back into the company. Consequently, this will happen because the cost of debt will reduce, resulting in high earnings before tax. Therefore, this case relates to the capital structure theory of net income approach and net operating income approach. Therefore this means the firm will have to reduce the leverage in the company which reduces the debt to equity ratio of a company thereby resulting in an increase in the value of the firm. In this case, the weighted average cost of capital decreases and the value of the firm will increase (Ardalan, 2017, pg.696).

Modigliani and Miller Approach

According to this capital structure theory, it stipulates that financial leverage in a firm boosts the value of the firm but however results into a reduction in the weighted cost of capital. The approach is the second proposition by Modigliani and Miller Approach. Thus, Cloudstreet Ltd may increase the total debt to equity ratio to boost its value and its weighted average cost of capital (Brusov et al., 2018, pg.9). Therefore, Cloudstreet ltd can increase the debt to equity ratio inorder to reduce cost of capital as well as increase the value of the firm.

Traditional Approach

Provides that the cost of capital of a firm is a component of a company’s capital structure. Therefore, a firm can achieve an optimal capital structure despite the changes in the ratio of debt and equity (Soheilirad et al., 2017, pg.363). Therefore a reduction in the cost of capital results into an increase in the value of the firm. Therefore Cloudstreet Ltd is justified to reduce the cost of capital by 1%.

The cost of capital comprises of both the cost of equity and the cost of debt of a company as it is estimated using the weighted average cost of each component of firm capital. An increase in a company’s weighted average cost capital shows that the return on investments in the firm for its investors. However, the amount of risk increase since the weighted cost of capital is used in the estimation of the present value of future cash flows of the company. Consequently, mangers need to make decisions which may lead to favourable terms for both investors and firms in terms of the weighted average cost of capital.

References

Ardalan, K., 2017. Capital structure theory: Reconsidered. Research in International Business and Finance, 39, pp.696-710.

Brusov, P., Filatova, T., Orekhova, N. and Eskindarov, M., 2018. Capital Structure: Modigliani–Miller Theory. In Modern Corporate Finance, Investments, Taxation and Ratings (pp. 9-27). Springer, Cham.

Kung, H. and Schmid, L., 2015. Innovation, growth, and asset prices. The Journal of Finance, 70(3), pp.1001-1037.

Shu, S.B., Zeithammer, R. and Payne, J.W., 2016. Consumer preferences for annuity attributes: Beyond net present value. Journal of Marketing Research, 53(2), pp.240-262.

Soheilirad, S., Sofian, S., Mardani, A., Zavadskas, E.K., Kaklauskas, A. and Darvishvand, J.M., 2017. The Relationship between Non-Financial Stakeholders and Capital Structure. Engineering Economics, 28(4), pp.363-375.