SCENARIO

Your team of three works in the Finance division of the North Melbourne Manufacturing Company Ltd. The company is in the process of deciding whether or not to purchase a new plastic injection machine. Your company’s Chief Financial Officer has asked you to make a recommendation as to whether or not the company should proceed with the project based on the following information:

A. Balance sheet and notes

North Melbourne Manufacturing Company Ltd

Balance Sheet as at 31/12/21

ASSETS

Cash                                            110

Accounts Receivable                  210

Inventory                                     620

Property, plant & equipment    1,170

2,110

LIABILITIES Notes

Accounts payable                                               140

Bank loan (interest only)                       1          250

Mortgage Loan                                      2           550

Corporate bonds                                    3 300

Total liabilities 1,240

SHAREHOLDERS’ EQUITY

Ordinary shares                                     4          410

Preference Shares                                  5          210

Total shareholders’ equity 870

Total liabilities and shareholders’ equity 2,110

Notes

1.   The interest rate on the bank loan is 8.8% p.a.

2.   The interest rate on the mortgage loan is 5.7% p.a.

3.   The corporate bonds have a credit rating of BBB+ and have 3 years to maturity. They require semi-annual coupon payments at a coupon rate of 8% p.a.

4.   The ordinary shares are shown on the balance sheet at their book value of $1 per share. They have a beta of 1.2. They are expected to pay a dividend of $0.10 next year. The dividend is expected to grow at a rate of 10% p.a. for the following 4 years and, after that, it will grow at a constant rate of 4% p.a. in perpetuity.

5.   The preference shares have a par value of $1 each and are shown on the Balance Sheet at their par value. They pay a constant dividend of $0.11, and they are currently trading for  $1.19.

6.   The market risk premium is 6.7%.

7.   The corporate tax rate is 30%. The 3-year risk-free rate is 2.93%. The 10-year risk-free rate is 3.56%

B. Credit Spread

C. Project Information

•   The equipment will cost $880, is expected to have a working life of 4 years, and will be depreciated on a straight-line to a book value of zero.

•   The equipment is expected to have a salvage value of $150 at the end of 4 years.

•   The new equipment will improve efficiency and result in increased revenue of $860 in its first year of operation, but because of reduced efficiency from normal wear and tear, revenue will decrease by 5% (from the previous year’s revenue) for each of the remaining

3 years of the equipment’s life.

•   Excluding maintenance, all other costs from operating the equipment will be $200 per year. Maintenance costs will amount to $140 in the equipment’s first year of operation and will then increase by $10 per year for the remaining 3 years of the equipment’s life.

•   The equipment will require additional net working capital of $200. The net working capital will be recovered in full after the equipment is sold at the end of its working life.

•   The equipment will be installed in a building that is owned by the company but currently is not being used. If the project does not proceed, this building could be rented out for $200 per year.

•   A feasibility study has been undertaken on the purchase of the new equipment. The cost of preparing the feasibility study was $500.

•   The company has sufficient capital to undertake all positive-NPV projects. If the Payback Period method is used to evaluate projects, management’s policy is that the maximum acceptable payback period is 4 years, and all cash flows in Year 0 would need to be recovered within 4 years for the project to be acceptable under this method.

TASKS

You are required to complete the following tasks (show your working with the calculations):

Part 1: Calculate the company’s Weighted Average Cost of Capital (30 marks)

a)   Calculate the before-tax cost of bank loans, mortgage loans, and corporate bonds (6 marks).

b)  Calculate the (market) value of bank loans, mortgage loans, and corporate bonds (6 marks).

c)   Calculate the cost of ordinary shares and preference shares (6 marks).

d)  Calculate the market prices of ordinary shares and preference shares (4 marks).

e)   Calculate the total market values of ordinary shares and preference shares (4 marks).

f)   Calculate the company’s WACC (4 marks).

Part 2: Estimate the project’s incremental free cash flows (30 marks)

a)   Prepare the depreciation table of the equipment (see examples in Topic 7 seminar). Round up to whole numbers (10 marks).

b)  Prepare the free cash flow table (see examples in Topic 7 seminar). Round up to whole numbers (20 marks).

Part 3: Calculate the project’s NPV, Payback Period, and Profitability Index (20 marks)

a)   Calculate NPV, Payback Period, and Profitability Index (10 marks).

b)  Should the project be accepted? Explain your answer (10 marks).

Part 4: Evaluate the company’s capital structure (20 marks)

a)   The North Melbourne Manufacturing Company Ltd belongs to the Capital Goods industry group under the Industrials sector. Identify  three firms that belong to the same industry group listed on the ASX, observe their debt ratios over the last five years, and determine whether the company is under or over-leveraged relative to its