Case Study-AW214

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Question 1

Don is the production manager of Temple Limited, a famous toilet roll manufacturer in Hong Kong. Currently he is reviewing the possibility of replacing the old machinery in order to boost production volume. The old machinery was purchased 4 years ago with a total cost of $4,800,000. It has a 10-year economic life with 6 years remaining with zero salvage value. If this machinery were to be sold today, it would be worth $2,880,000. The company uses the straight line depreciation method on all production machineries. The firm’s cost of capital is 12% with marginal tax rate of 25%.
The new machinery is proposed by ECG Consulting, a well-known business consulting firm in the manufacturing field. The purchase price of the proposed machinery would be $5,400,000. In addition, the company would have to incur $300,000 shipping and installation costs and $600,000 investment in net working capital. The economic life of the new
machinery is 6 years with zero scrap value. It is expected that the new machinery can reduce before-tax operating expenses by $880,000 every year. The company had paid $75,000 to ECG Consulting to obtain the assessment report regarding this replacement recommendation.
Answer the following questions

a What is the initial outlay associated with this proposed purchase?
b What are the annual after-tax cash flows associated with this proposed purchase, for years 1–5?
c What is the amount of after-tax cash flow that should appear in year 6?
d Calculate the net present value (NPV) of this replacement decision. Would you accept or reject the purchase of the new machinery?
Question 2

Black Rocket is a private equity firm investing in hi-tech projects. The company uses 12% discount rate for its investments. Recently Black Rocket has two potential projects on hand, code named Project X and Project Y. The firm is now considering investing in one project amongst these two candidates. The projected after-tax cash flows of the two projects are as follows
After-tax cash flows ($)
Year Project X Project Y
0 -3,000,000 -3,000,000
1 780,000 600,000
2 780,000 800,000
3 780,000 1,300,000
4 780,000 1,600,000
5 420,000
6 420,000
7 420,000
8 420,000
Answer the following questions

a Using the equivalent annual annuity (EAA) method, advise Black Rocket on which project the firm should choose.
b Define the time disparity problem and the unequal life span problem and their implication in project selection. Explain which problem appears in this case.
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Question 3

Chinatown Gas Corporation (CGC) is a utility company providing liquefied petroleum gas (LPG) to households in Hong Kong. The business of CGC has been stagnant in recent years and the board of directors wants to increase the company’s revenue by investing overseas. One of the candidate projects is a diamond mining business in Sierra Leone in West Africa.
The management believes this project can bring a huge profit to the company in future.As a business analyst of the CGC, you have been asked by the board to determine an appropriate discount rate to evaluate this mining project. As a student of FIN B280, you would like to identify the Weighted Average Cost of Capital (WACC) of your company first. The information about the current capital structure of CGC is as follows

i 3,600,000 shares of common stock with a par value of $1.0, currently trading at $25 per share.
ii 1,500,000 shares of 6% preferred stock with a par value of $50. These preferred stocks are currently trading at $40 per share in the market.

iii 80,000 units of 10-years, 8% p.a. coupon bonds with semi-annual interest payment. The bond has exactly 3 years to maturity with par value of $1,000. The current quotation of this bond is 104.3, which means 104.3% of its par value. Bonds with similar risk, interest term and maturity are currently selling at 6.40% p.a. yield to maturity.
iv An $80,000,000 long-term bullet payment loan with Open Bank. The loan was borrowed a year ago with 7% p.a. borrowing rate. The market value of this bank loan is not available.

v The expected market return is 10%, the risk-free rate is 3% and beta of CGC’s common stock is 0.88 respectively. The marginal tax rate is 25%.
Answer the following questions

a What is the capital structure of CGC on a market value basis? Please make assumptions in your calculation if necessary
b Evaluate the weighted average cost of capital (WACC) of Chinatown Gas Corporation.
c Discuss in detail whether Chinatown Gas Corporation should use its WACC as the benchmark to evaluate the diamond mining project.
Question 4

Kiwi Production is a manufacturer of electrical appliances. The company is preparing a financial plan for the coming year and has the following independent kitchen appliance projects under consideration

Project Initial investment ($ million)
Internal rate of return
A 220 20.50
B 250 17.00
C 170 22.00
D 260 17.50
E 190 18.30
Assume the above projects have the same risk as that of the company and the cost of capital (WACC) of Kiwi Production is 18%. The chief financial officer estimates that earnings after tax in this financial year wil be $170 million. Kiwi Production has 8 million shares outstanding, and the board would like to maintain a debt-to-equity ratio (D/E) of 4.
Answer the following questions

a Based on the above information, determine the major criteria for Kiwi Production to select project(s). With such criteria, which project(s) should be accepted by the company? Calculate the firm’s total planned capital expenditure for the coming year.
b Suppose Kiwi Production follows a residual dividend policy. What will be the company’s dividend per share?
c Provide TWO major disadvantages of a strict residual dividend policy. How does a compromise dividend policy differ from a strict residual dividend policy?
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