FIN1FOF- Fundamentals of Finance GROUP ASSIGNMENT

GUIDELINES

• This assignment requires students to prepare a detailed business report based on a case study by applying financial concepts such as capital structure, capital budgeting, and others in topics 1-7 in the course.
• This is a group assignment marked out of 100 and contributes 30% of your overall assessment for FIN1FOF. Students need to form a group of three to complete this assignment.

Your report must be submitted via “Assignment Dropbox” on the FIN1FOF subject LMS site by 11:59 pm on Sunday 8^th May 2022. Hard copies will not be accepted. Make sure you have successfully attached your submission before submitting and exiting the Dropbox. Make sure you receive an email confirmation of your submission. If you aren’t sure, go back into Dropbox and check that your submission is attached.

SCENARIO

Your team of three works in the Finance division of the Carlton 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

Carlton Manufacturing Company Ltd
Balance Sheet as at 31/12/21
ASSETS		LIABILITIES	Notes
Cash	140	Accounts payable		120
Accounts Receivable	200	Bank loan (interest only)	1	240
Inventory	610	Mortgage Loan	2	530
Property, plant & equipment	1,200	Corporate bonds	3	300
Total Assets	2,150	Total liabilities		1,190
		SHAREHOLDERS’ EQUITY
		Ordinary shares	4	430
		Preference Shares	5	250
		Retained earnings		280
		Total shareholders’ equity		960
		Total liabilities and shareholders’ equity	2,150

Notes

1. The interest rate on the bank loan is 8.2% p.a.
   1. The interest rate on the mortgage loan is 5.9% p.a.
   1. The corporate bonds have a credit rating of AA and have 2 years to maturity. They make quarterly coupon payments at a coupon rate of 7% p.a.

• 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 have just paid a dividend of $0.07. The dividend is expected to grow at a rate of 7% p.a. for the next 3 years, and after that, it will grow at a constant rate of 3% p.a. in perpetuity.
  • 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 $0.10, and they are currently trading for

$1.2.

• The risk premium for ordinary shares is 8%.
  • The corporate tax rate is 30%. The 2-year risk-free rate is 0.03%. The 10-year risk-free rate is 1.14%

B.  Credit Spread

Rating	1 yr	2 yr	3 yr	4 yr	5 yr	6 yr	7 yr	8 yr	9 yr	10 yr
AAA	128	168	208	248	288	328	368	408	448	488
AA+	139	179	219	259	299	339	379	419	459	499
AA	150	190	230	270	310	350	390	430	470	510
AA-	161	201	241	281	321	361	401	441	481	521
A+	172	212	252	292	332	372	412	452	492	532
A	183	223	263	303	343	383	423	463	503	543
A-	194	234	274	314	354	394	434	474	514	554
BBB+	205	245	285	325	365	405	445	485	525	565
BBB	216	256	296	336	376	416	456	496	536	576
BBB-	227	267	307	347	387	427	467	507	547	587
BB+	238	278	318	358	398	438	478	518	558	598
BB	249	289	329	369	409	449	489	529	569	609
BB-	260	300	340	380	420	460	500	540	580	620
B+	271	311	351	391	431	471	511	551	591	631
B	282	322	362	402	442	482	522	562	602	642
B-	293	333	373	413	453	493	533	573	613	653
CCC+	304	344	384	424	464	504	544	584	624	664
CCC	315	355	395	435	475	515	555	595	635	675
CCC-	326	366	406	446	486	526	566	606	646	686
CC	337	377	417	457	497	537	577	617	657	697
C	348	388	428	468	508	548	588	628	668	708

• Project Information

• The equipment will cost $720, is expected to have a working life of 4 years, and will be depreciated on a diminishing-value basis to a book value of zero.
• The equipment is expected to have a salvage value of $120 at the end of 4 years.
• The new equipment will improve efficiency and result in increased revenue of $850 in its first year of operation, but because of reduced efficiency from normal wear and tear, revenue will decrease by 4% (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 $280 per year. Maintenance costs will amount to $120 in the equipment’s first year of operation and will then increase by $30 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 $400.
• 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 3 years, and all cash flows in Year 0 would need to be recovered within 3 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)

1. Calculate the before-tax cost of bank loans, mortgage loans, and corporate bonds (6 marks).
2. Calculate the (market) value of bank loans, mortgage loans, and corporate bonds (6 marks).
3. Calculate the cost of ordinary shares and preference shares (6 marks).
4. Calculate the market prices of ordinary shares and preference shares (4 marks).
5. Calculate the total market values of ordinary shares and preference shares (4 marks).
6. Calculate the company’s WACC (4 marks).

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

1. Prepare the depreciation table of the equipment (see examples in Topic 7 seminar). Round up to whole numbers (10 marks).
2. 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)

1. Calculate NPV, Payback Period, and Profitability Index (10 marks).
2. Should the project be accepted? Explain your answer (10 marks).

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

1. The Carlton Manufacturing Company Ltd belongs to the Industrial sector. Identify three Industrial firms 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 peers (no more than 200 words) (10 marks).

• Discuss the advantages and disadvantages of debt financing (no more than 300 words) (10 marks).