Case study one
You have been hired as a financial consultant to Tamar Circuitry Ltd (TCL), a large publicly traded firm that is the market share leader in radar detection systems (RDS). The company is looking at setting up a manufacturing plant overseas to produce a new line of RDS’s. This will be a five year project. The company bought some land three years ago for $4 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $5.1 million. In five years, the after tax value of the land will be $6 million, but the company expects to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost $35 million to build. The following market data on TCL’s securities are current:
Debt: 240,000 7.5 percent coupon bonds outstanding, 20 years to maturity, currently trading at $940; the bonds have a $1,000 par value each and make semi-annual payments.
Ordinary Share: 9,000,000 shares outstanding, selling for $71 per share; the beta is 1.2.
Preference Share: 400,000 shares of 5.5 percent preferred stock outstanding, with a face value of $100, selling for $81 per share.
Market: 8 percent market risk premium; 5 percent risk – free rate.
TCL uses Shylock Ltd as its lead underwriter. Shylock charges spreads/flotation costs of 8 percent on new share issues, 6 percent on new preference share issues and 4 percent on debt issues. Shylock has included all direct and indirect issuance costs (along with its profits) in setting these spreads/flotation costs. TCL’s tax rate is 35 percent. The project requires
$1,300,000 in initial net working capital investment to reach operational stage. Assume Shylock raises all additional financing needed for new projects externally.
- Calculate the project’s initial investment at time 0, taking into account all side effects including weighted flotation costs. [1.5 marks]
- The new RDS project is somewhat riskier than a typical project for TCL, primarily because the plant is located overseas. Management has told you to use an adjustment factor of + 2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating TCL’s project. [2 marks]
- The manufacturing plant has an eight year tax life, and TCL uses straight line depreciation. At the end of the project (that is, the end of year 5), the plant and equipment can be scrapped for $6 million dollars. What is the after tax salvage value of this plant and equipment? [1 mark]
- The company will incur $7,000,000 in annual fixed costs. The plan is to manufacture 18,000 RDS’s per year and sell them at $10,900 per machine; the variable production costs are $9,400 per RDS. What is the annual operating cash flow (OCF) from this project? [1 mark]
- TCL’s financial controller is primarily interested in the impact of TCL’s investments on the bottom line of reported accounting statements. What will you tell her is the accounting break even quantity of RDS’s sold for this project?
- Finally, TCL’s chief executive officer (CEO) wants you to prepare a draft report only showing what the RDS project’s internal rate of return (IRR) and net present value (NPV). [3 marks]
- What will you report to the CEO? Include in your response to him the reasons why the NPV and IRR methods may give different answers in terms of accepting or rejecting projects. Explain the reasons for the conflict, and discuss how the conflict can be resolved. (250 words)
Case study two
Seven years ago, after 15 years in public accounting, Albert Hooker, FCPA, resigned his positions as manager of systems for Cooke, Bray and Jackson Public Accountants and started Montage Software Limited. In the two years preceding his departure from Cooke Bray and Jackson, Albert had spent nights and weekends developing a sophisticated cost accounting software program that became Montage’s initial product offering. As the firm grew, Albert planned to develop and expand the software product offerings – all of which would be related to streamlining the accounting process of medium – to large sized manufacturers.
Although Montage experienced losses during its first two years of operation – 2010 and 2011
– its profit has increased steadily from 2011 to the present (2016). The firms profit history, including dividend payments and contributions to retained earnings, is summarised in Table 1.
Albert started the firm with a $100,000 investment – his savings of $50,000 as equity and a
$50,000 long-term loan from the bank. He had hoped to maintain his initial 100% ownership in the corporation, but after experiencing a $50,000 loss during the first year of operation (2010), he sold 60% of the shares to a group of investors in order to obtain needed funds.
Since then, no other share transactions have taken place. Although he owns 40% of the firm, Albert actively manages all aspects of its activities; the other shareholders are not active in the management of the firm. The shares closed at $4.50 in 2015 and at $5.28 in 2016.
Albert has just prepared the firm’s 2016 income statement, balance sheet and statement of retained earnings, shown in Tables 2, 3 and 4, along with the 2015 balance sheet. In addition, he compiled the 2016 ratio values and industry average values, which are applicable to both 2013 and 2016. These are summarised in Table 5. Albert is quite pleased to have achieved record earnings of $48,000 in 2016, but he is concerned about the firm’s cash flows.
Specifically, he is finding it more and more difficult to pay the firm’s bills in a timely manner. To gain insight into these cash flow problems, he is planning to prepare the firm’s 2016 operating cash flow and free cash flow.
Albert is further frustrated by the firm’s inability to afford to hire a software developer to complete development of a cost estimation package that is believed to have ‘blockbuster’ sales potential. Albert began development of this package two years ago, but the firms growing complexity has forced him to devote more of his time to administrative duties, thereby halting the development of this product. Albert’s reluctance to fill this position stems from his concern that the added $80,000 per year in salary and benefits for the position would certainly lower the firms earning per share (EPS) over the next couple of years. Although the project’s success is no way guaranteed, Albert believes that, if the money were spent to hire the software developer, the firm’s sales and earnings would rise significantly once the two to three year development, production and marketing process was completed.
With all these concerns in mind, Albert set out to review the various data to develop strategies that would help to ensure a bright future for Montage Software. Albert believed that, as part of this process, a thorough ratio analysis of the firm’s 2016 results would provide important additional insights.
- a) On what financial goal does Albert seem to be focusing? Is it the correct goal? Explain your answer.
- b) Could a potential agency problem exist in this firm? Explain. (1.5 Marks)
- Calculate the firm’s earnings per share (EPS) for each year, recognising that the number of shares issued has remained unchanged since the firm’s inception. Comment on the EPS performance in view of your response to question 1a.
- Use the financial data presented to determine Montage’s operating cash flow (OCF) and free cash flow (FCF) in 2016. Evaluate your findings in light of Montage’s current cash flow difficulties. (1.5 Marks)
- Analyse the firm’s financial condition in 2016 as it relates to a) liquidity, b) activity,
- c) debt and d) probability, using the financial statements provided in Tables 2 and 3 and ratio data included in Table 5. Be sure to evaluate the firm on both a cross- sectional and a time-series basis. (3 Marks)
- What recommendations would you make to Albert about hiring a new software developer? Relate your recommendation here to your responses to question 1a.