PART 1: CALCULATING THE COST OF CAPITAL
Your analysis of your client's financial position has been very helpful in enabling the firm to identify strengths and weakness, and make changes to capitalise on its strengths and tackle its weaknesses. Based on your advice, changes have been made and will be made to improve the firm's financial position and position it to take on new projects and expand into new markets.
It is now February 2022. Your client has identified a number of potential new projects that the firm could undertake, but isn't sure how to decide which ones to go ahead with. Your client has asked for your advice. You have initially explained to your client that the first thing to do is to work out the firm's Weighted Average Cost of Capital, because that is the minimum return required on new projects in order meet the cost of capital and maintain or increase the value of the firm. Your client has therefore provided the most recent set of financial statements, as at 31 December 2021 (see Part 3), and has asked you to calculate the firm's WACC based on the sources of capital shown in its most recent Balance Sheet.
Your task:
1. Determine the cost of all sources of capital (i.e. all non-current liabilities, ordinary shares and preference shares). (Note: Do not include Retained Earnings. Since all reserves, including retained earnings, belong to the owners of the ordinary shares, we assume that the market value of the ordinary shares includes the value of these reserves.)
2. Determine the market value of all sources of capital (excluding retained earnings).
3. Calculate the firm's Weighted Average Cost of Capital.
In order to carry out this task, you have asked for and received the following additional information from your client:
The interest rate on the Bank Loan is 11.4% p.a.
The interest rate on the Mortgage Loan is 9.4% p.a.
The corporate bonds are rated BBB-, have 7 years to maturity and pay a quarterly coupon at a rate of 7.9% p.a.
The ordinary shares have a beta of 1.35.
The preference shares pay a fixed annual dividend of 15 cents per share.
Shown below is a table of credit spreads for different credit ratings and terms to maturity, the yield on Australian Government Securities for various terms to maturity, and the market risk premium. To determine the cost of the corporate bonds, find the relevant credit spread (shown in basis points, where a basis point 1/100th of 1%) based on the bonds' credit rating and term to maturity, and add this to the risk-free rate that matches the term to maturity of the corporate bonds. You should use the yield on 10-year Government Securities to represent the risk-free rate in the Capital Asset Pricing Model.
|
Standard and Poor's Credit Spreads
|
|
Credit Rating
|
3-year
|
5-year
|
7-year
|
|
AAA
|
129
|
159
|
189
|
|
AA+
|
140
|
170
|
200
|
|
AA
|
151
|
181
|
211
|
|
AA-
|
162
|
192
|
222
|
|
A+
|
173
|
203
|
233
|
|
A
|
184
|
214
|
244
|
|
A-
|
195
|
225
|
255
|
|
BBB+
|
206
|
236
|
266
|
|
BBB
|
217
|
247
|
277
|
|
BBB-
|
228
|
258
|
288
|
|
BB+
|
239
|
269
|
299
|
|
BB
|
250
|
280
|
310
|
|
BB-
|
261
|
291
|
321
|
|
B+
|
272
|
302
|
332
|
|
B
|
283
|
313
|
343
|
|
B-
|
294
|
324
|
354
|
|
CCC+
|
305
|
335
|
365
|
|
CCC
|
316
|
346
|
376
|
|
CCC-
|
327
|
357
|
387
|
|
CC
|
338
|
368
|
398
|
|
C
|
349
|
379
|
409
|
PART 2: PROJECT EVALUATION
There is one particular project the firm is considering. Now that you have calculated the firm's cost of capital, you are in a position to use it to recommend to the client the acceptance or rejection of the project that is under consideration.
The project in question involves the acquisition of a new machine which will enable the firm to increase production of prefabricated homes. The firm has provided the information about this project, shown below.
Your task:
1. Determine the incremental free cash flows that would result from the acceptance of this project.
2. Calculate the NPV of the incremental free cash flows.
3. Provide the firm with your recommendation as to whether it should accept or reject this project.
Project information. (All values are in thousands of dollars.)
A feasibility study has been undertaken at a cost of $13, which has generated the following data.
The machine will have a useful working life of 4 years. It will cost $200 to purchase and install. This cost will be depreciated over the life of the project to a book value of zero using diminishing-value depreciation. The machine is expected to have a salvage value of $24, which will be received in Year 5.
The project will require an increase in net working capital of $16, which will be recovered in Year 5, after the machine is disposed of.
The new machine will generate increased revenue of $140 in its first year of operation. However, due to increased wear and tear, the output of the machine, and hence the level of additional revenue, in Years 2, 3 and 4, will decrease each year by 3% from the previous year.
Use of the new machine will require an additional $41 per year in wages. It will also incur additional maintenance costs of $11 in the first year. Because of additional wear and tear, this maintenance cost will then increase by $3 per year for the remaining life of the machine.
The machine will be installed in a building already owned by the firm. If this project does not go ahead, this building could be rented out for $15 per year.
Attachment:- Assignment Files.rar