The assignment consists of two individual practical tasks where students are required to apply capital budgeting techniques and perform a risk analysis on a project.
For this work, you are to apply capital budgeting techniques and perform a project risk analysis assessment:
Task 1: Fystrom Chemicals
Role and Context
You are a financial analyst in the capital projects department of Fystrom Chemicals, a speciality chemicals producer of fire-control chemicals, additives, and pesticides based in Queensland. Currently, Fystrom is small in scale, but embarking on a rapid expansion and modernization program. It is also expanding its range of products into dyes, rubber compounds, and water treatment chemicals. Along with the projects considered here, Fystrom is also currently undertaking evaluation of projects expanding its existing facilities in SE Queensland, the acquisition of another chemicals producer in Victoria, a joint venture with a US company producing fuel additives, and various production and warehouse upgrades in a number of smaller plants in NSW and South Australia.
While Fystrom has a large and expanding capital budget, it is currently considering which of two possible projects it should invest in, both of which will be used to manufacture furfural (an organic compound derived from agricultural by-products) and furfural-based derivatives to make resins, urethanes, and refining solvents over a 10-year operating period.
Scenario
The first project, the Djakarta Plant, is a proposed new plant in Indonesia, about 30 km outside the capital. Fystrom has been considering this expansion for a number of years and believes that the combination of low wages, looser environmental protection, and proximity to its emerging markets in SE Asia will makes this new plant an attractive addition to its existing facilities. Specifically, now in 2017, the Djakarta Plat will require the purchase of land for $2.75 million, with development and construction building costs of $13 million, and plant and equipment of $6 million. Fystrom will also need to spend on working capital in the amount of 6% of sales every year during the life of the project. Sales are estimated to be $48.6 million first year of production in 2018, increasing by 10% per annum.
The cost of goods sold is 65% of sales. Fixed costs will be $11.5 million in 2018, increasing by 5% per year. Both buildings and plant/equipment will be depreciated straight line to zero over the 10-year project life. The buildings will have a salvage value of 20% of cost and the plant and equipment will have no salvage value. At the end of the project, Fystrom will rehabilitate the site and sell the land for light industrial development for $17.8 million. The company tax rate in Indonesia is normally 25%, but the new government is offering an incentive for the first three years of operation for major manufacturing projects where the tax rate will only be 20% before reverting to the normal rate.
The second project, the Gladstone Plant, is a modification of an existing plant Fystrom already owns in the city of the same name in north Queensland. The Gladstone Plant has been idle for a number of years, but with renovation would be well suited to furfural production. If not used for the proposed project, Fystrom will lease out the existing plant for $60,000 after tax per year. The estimated development and construction building costs will be $15 million this year in 2017, alongside plant and equipment investment of $5 million. Fystrom will again need to invest in working capital in the amount of 6% of sales every year when production commences in 2018. Sales will be $45 million in the first year of production in 2018, increasing by 7% per annum.
Given the relative geographic isolation of the plant and the stricter environmental controls given the proximity to the Great Barrier Reef, the cost of goods sold will be 75% of sales. Fixed costs will be $4 million in 2018, increasing by 5% per year. Both buildings and plant/equipment will again be depreciated straight line to zero over the 10-year project life. The buildings will have a salvage value of 20% of cost and the plant and equipment will have no salvage value.
At the end of the project, the Gladstone Plant will again revert to being idle awaiting potential future developments at no cost. The company tax rate in Australia is 30%.
Task - Recommend to Fystrom's CFO, Ms. Penelope Jenkins, in which of these two mutually exclusive projects Fystrom should invest, if any. Assume Fystrom has a cost of capital of 12% for domestic projects and 15% for international projects.
Task 2: Cascade Water Company
Role and Context
You are a newly hired financial analyst with Cascade Water Company (CWC), a company operating in most states of Australia, which specialises in bottling purified water sourced from local water springs. CWC is considering adding to its product mix a 'healthy' bottled vitamin water geared towards children, aimed at improving both its business focus and the return to shareholders.
Scenario
CWC currently has 30,000,000 ordinary shares outstanding that trade at a price of $42 per share. CWC also has 550,000 bonds outstanding that currently trade at $941 each. The company's bonds have a 20 year life, a $1,000 par value and a 9% coupon rate that pays interest semi-annually. CWC has no preferred equity outstanding. The equity beta is 0.95. The risk free rate is 2.5% and the market is expected to return 12.75%. CWC has a tax rate of 35%.
The initial outlay for the new project is expected to be $3,000,000, which will be depreciated over 3 years using the straight line method to a zero salvage value, and sales are expected to be 1,250,000 units per year at a price of $2.15 per unit. Variable costs are estimated to be $0.54 per unit and fixed costs are estimated at $50,000 per year. The project is expected to have an indefinite life, however the company has estimated a terminal value in year 3 (excluding the operating cash flow) of $500,000. For the purpose of this project, working capital effects are ignored.
CWC's CEO, Dr. William Foster, has asked the finance department if they consider such project to be an acceptable investment. The CFO, Mrs. Charlotte O'Rourke, intends to evaluate the project based on the net present value approach. She agrees with Dr. Foster on the major assumptions that will affect these cash flows, but they disagree on the appropriate discount rate. Dr. Foster believes that they should use the company's weighted average cost of capital (WACC), however, the CFO disagrees, arguing that the bottled water targeted at children has different risk characteristics from the company's current products.
She argues that the company's WACC is inappropriate as a discount rate and they should instead use the 'pure play' approach and estimate a cost of capital based on companies that sell similar type of riskier products. To do this, Mrs. O'Rourke obtains some data for several comparable companies as follows:
|
Company
|
Cost of Equity
|
Cost of Debt
|
D/E
|
Tax Rate
|
|
Fruity Water
|
21.2%
|
8%
|
0.43
|
34%
|
|
Ladybug Drinks
|
19.7%
|
7.75%
|
0.35
|
36%
|
Task
1. The CEO and CFO have decided to rely on your newfound expertise as to provide a recommendation on the appropriate discount rate to be used in the NPV technique to evaluate the new project.
2. Concerned about the forecasting risk of this project, they also ask that you perform a risk evaluation on the base case NPV in the form of: A sensitivity analysis for sales price, variable costs, fixed costs and unit sales at ±10%, ±20%, and ±30% from the base case, showing on a graph which variables are most sensitive;
Scenario analysis on the following two scenarios:
a) Worst Case: selling 950,000 units at a price of $1.85 and variable cost of $0.63 per unit;
b) Best Case: selling 1,550,000 units at a price of $2.25 and variable costs of $0.49 per unit.
3. Finally, advise the CEO and CFO whether this project is an acceptable investment taking in consideration the capital budgeting technique used and the risk analysis performed.
Attachment:- Assignment File.rar