Finance-AW-Q63

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QUESTION 1
 
Ocean Blue Charters Ltd (OBC Ltd) is a Raglan based company.
 
Its financial position at 31 December 2014 is as follows
 
Current assets 160,000 Current liabilities 100,000
Non-current assets 400,000 Non-current liabilities 200,000
Investments –shares 40,000 Equity:
in other companies Preference capital 50,000
_________ Ordinary capital 250,000
$600,000 $600,000
 
The issued capital comprises 25,000 non-voting 10% Preference shares which are preferential as to both dividends and return of capital in the event of winding up and 250,000 Ordinary shares. There are no retained earnings at 31 December 2014.
 
OBC Ltd needs to raise funds for a proposed expansion. The company wishes to maintain the current proportions of long-term debt:equity. Funds can be raised as follows:
 
• It can sell seven-year, $1,000 face-value bonds with a 9% annual coupon interest rate for $1,000. The cost of issuing these is $50 per bond.
 
• It can sell unlimited 10% preference shares at their par value of $2 per share, but this will cost 15c per share in issuing costs. The preference shares will be preference as to both dividends and return of capital in the even of winding up.
 
• OBC’s ordinary shares currently sell for $2.40 per share. New ordinary shares can be sold for the same price, but issue costs of 10% of the price will be incurred.
 
OBC expects to pay a dividend of 25c per ordinary share next year (2015). Dividend growth of 10% per annum is expected in the future.
 
OBC Ltd owns an existing boat which was purchased on 1 January 2013 for $600,000 and is being depreciated at 20% per annum using the prime cost method with an estimated residual value of zero.
 
It could be sold on 1 January 2015 for $450,000 before taxes. If it is not sold on that date, it can be used for another four years (depreciated using the prime cost method, with a zero residual value) then sold to net $150,000 before taxes at the end of 2018.
 
Since its purchase, the company has leased this existing boat on an annual basis to John Dory, an experienced boatman, for $212,500 per annum. John has been responsible for all the maintenance and running costs of the boat.
 
The only expenses OBC currently incurs annually are depreciation of the boat and interest of $12,000. No changes in interest are expected in the next four years.
 
John is unable to meet the increasing public demand for such trips with the existing boat and has suggested that OB purchase a larger boat, which he is prepared to captain as an employee for the company, but he does not wish to lease it. If OBC does not purchase a new boat, John will continue with the existing arrangement he has with the company for another four years, with a 5% annual increase in his lease cost commencing 1 January 2016.

 
A new fully equipped, all-weather boat can be purchased for $1,250,000. It would be depreciated over four years using the prime-cost method with an estimated residual value of zero. If it is purchased, the first trip will take place on 1 January 2015.
 
Assume the new boat could be sold for $250,000, at 31 December 2018.
 
If this boat is acquired, it is anticipated that the following current account changes would result:
Bank +16,000
Accounts receivable +7,300
Accounts payable -8,000
 
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An analysis and estimate of the first year’s (2015) income and costs associated with the purchase of a new boat shows the following
 
Annual passenger numbers 30,000
Fare per passenger $45

Costs
Wages 310,000
Variable costs 400,000
Fixed overheads (excluding depreciation) 125,000
 
Fixed overheads include moorage fees, DOC license fees, insurance, cleaning expenses, advertising, etc. Variable costs include diesel, food, drinks, etc.
 
Market development costs of $50,000 have been incurred and capitalised in the 2014 financial year. These will be amortised on a straight-line basis over the four-year life of the new boat if it is purchased. If the new boat is not purchased, these costs will be written off in the 2014 financial year, as those accounts have not yet been finalised. Market development costs are tax deductible in the year they are amortised.
 

The following changes are expected over the four-year period
 
• Passenger numbers will increase by 5% in 2016 and 6% in 2017 to the maximum the boat can accommodate.

• The fare will increase by 3% per annum.

• Labour costs will increase by 4% each year.

• Variable costs will increase by 6% in 2016 and by 2.5% per annum thereafter.

• Fixed overhead costs (excluding depreciation) will increase by 2% per annum.

The company undertakes projects with a payback period of less than 2.25 years, provided the NPV is positive.
 

 

REQUIRED
  TOTAL MARKS: 100

PART A VIABILITY OF THE INVESTMENT
 
1. Calculate the weighted average cost of capital. (Use tax rate of 30%) 4 marks

 

2. Calculate
a. the initial investment, and
b. the terminal cash flow. 3 marks

 

3. Assuming the expansion starts in 2015, show
a. the operating net cash flows for the existing boat for the four years, and
b. in ONE statement, the incremental operating cash flows associated with the new boat and the discounted value of those cash flows for the four years.
18 marks

 

4. Calculate the
i. payback period
ii. NPV
iii. IRR
iv. profitability index
v. discounted payback period
(Use your WACC calculated in (1) above where appropriate. 6 marks
 
5. Because OBC Ltd would now be undertaking an active investment/venture (rather than a passive investment), one director, Albert, doesn’t think sufficient attention has been paid to risk. He is a director of another company that establishes “risk classes” and believes the risk of OBC’s new boat venture is in the “above-average risk class” and therefore the discount rate used to assess the viability should be increased by 15%.
 
Henry, another director, wants to use the CAPM to determine the required rate of return/discount rate, but the other directors and the company accountant do not, as they say it is not really valid for OBC and the current proposed project.
 
Required
 
a. If the discount rate was increased by 15% and Albert has the final “say”, would OBC proceed with purchasing the new boat? Show workings. 4 marks

 
b. Briefly explain why the CAPM is not really valid for assessing the risk of this project for OBC. (You must provide at least 3 reasons for lack of validity). 3 marks
 
c. Identify and briefly explain in your own words the various issues that could increase the risk of not achieving the results you calculated in (3) above, and affect the viability of the investment.
4 marks

 
6. Write a brief report, stating with reasons and with reference to your answers above whether OBC Ltd should buy the new boat.
10 marks

 

PART B IMPLICATIONS FOR WORKING CAPITAL MANAGEMENT
 
7. Explain why the working capital would change as a result of buying the boat. 6 marks

PART C FINANCING OF THE INVESTMENT
 
8. Given that OBC wishes to maintain the current proportions of long-term debt:equity to finance the expansion, calculate
 
a. The maximum debt that can be borrowed,
b. The number of preference shares to be issued and the proceeds receivable,
c. The number of ordinary shares to be issued and the proceeds receivable.
4 marks

 

9. OBC has not decided how it will finance the purchase of the new boat. Compare and contrast the following sources of finance from the company’s point of view. (You need to consider advantages and disadvantages of each source).
 
a. Mortgage
b. Bond/debentures
c. Finance leases 20 marks

 
10. If OBC did not wish to maintain its current debt:equity ratio, it could borrow the full cost ($1.25million) of the new boat or it could lease it.
 
Option 1: Buy the boat
 
Cost $1,250,000
Estimated useful life 4 years
Estimated residual value
(estimated sale price in 4 yrs time) $250,000
Depreciation is to be based on depreciable cost
Annual maintenance contract
(payable at the end of each year) $20,000
Loan required $1,200,000
Interest rate on loan 9%
Term of loan 4 years
Payments Annual – year end
 
Option 2: Lease the boat
 
Annual lease payments $320,000
Payments At beginning of each year
Purchase option at end of lease $250,000
Annual maintenance contract
(payable at the beginning of the year) $20,000
The purchase option is unlikely to be exercised
 
NOTE: Use the after-tax k that you calculated in Part A (1).
 
Required
 
a. Determine with reasons whether OBC Ltd should buy or lease the boat. Show all your workings clearly. 11 marks
 
b. What non-financial factors would OBC Ltd also consider when making the decision on whether to lease or buy the boat. Give reasons for your answer.
2 marks

 

Formulae for question 1-4 and 10 above 5 marks

 
Product Code-Finance-AW-Q63
 
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