Country : Australia
Assignment Task:

QUESTION 1  

Kate Murphy has been looking for a small business to purchase for the last six months since she was made redundant from her previous job.  Her attention has been drawn to a juice bar in the Rundle Mall shopping precinct in Adelaide that is for sale.  Discussions with the current owner indicate that the business could be purchased for $270,000. The owner also disclosed that the juice bar sells 150,000 juice cups a year at an average price of $4.00 per disposable cup.  Kate decided to investigate the business further. Based on her own analysis, she estimates that the fixed costs of the business are $200,000 a year, and variable costs are $2.00 per cup. The juice bar has five year’s remaining on a lease at the end of which it will be dismantled as part of a major renovation project for the shopping centre in which it is located.  Kate estimates that the depreciable value of the equipment and fittings that would be acquired with the business would be $100,000, and can be depreciated on a straight-line basis over five years for tax.  She also estimates that the salvage value of the equipment and fittings would be around $20,000 in five years.

  1. Based on the above information, and given a required return of 15% and a tax rate of 25%, what is the estimated net present value of this business? (15 marks)

  2. Kate is aware that the results in a) are based on sales projections provided by the current owner of the business.  She knows that she needs to examine the sales figure more closely. Calculate the number of juice cups that would need to be sold annually to achieve a financial breakeven.  

  3. Based on the analysis in parts a) and b), should Kate purchase the business? (10 marks)

QUESTION 2 

MacPherson Development Ltd was founded in 1999 by the current CEO, Jamie MacPherson.  The company has been involved in property development from its beginning, acquiring over the years a portfolio of large tracts of land suitable for both residential and commercial development across Adelaide.  The company has long had a policy of steady development of its land over time in tune with market demand.  This policy has enabled the company to report profits every year since 2002, and was a major factor behind the company successfully listing on the Australia Securities Exchange five years ago.  Jamie is very proud of the history of the company, especially since a previous business venture he was involved in had failed.  This experience made him extremely adverse to debt financing.  As a result, the company is entirely equity financed.  It has 8 million shares outstanding currently trading at $37.80 per share.

The company is evaluating the purchase of a large tract of land in Port Adelaide for $85 million.  Jamie is aware of the large naval ship building projects underway and planned for the Port Adelaide/Osborn areas, and is confident that the land would be a desired location for other companies involved in the supply chain for the shipbuilding activities for many years into the future.  MacPherson Development would develop the land for heavy and light industrial use and lease the facilities on a long-term basis to other companies.  Jamie strongly believes that long-term leases would suit potential clients because of the long-term commitment and investment necessary to naval shipbuilding activities.

Tania Wong, the company’s new CFO has been asked to take charge of the evaluation of this project.  Tania has been involved in similar projects in Britain and this was a major factor in her recruitment to this position.  After reviewing the work already undertaken by the project evaluation team, she is confident that the development would increase the company’s pre-tax earnings by $14.125 million in perpetuity.  She and the project team have estimated the company’s current cost of capital to be 10.2%.

Based on her UK experience, Tania believes the company would be more valuable if it included debt in its capital structure.  She sought Jamie MacPherson’s approval to investigate this change.  Although somewhat reluctant, Jamie realised that if change is to be made to the company’s capital structure, now would be a good time as it could be achieved as part of the capital raising scheme for the proposed Port Adelaide project investment.

Tania spent a number of weeks meeting with representatives of a number of investment banks interested in assisting the company in its capital raising.  She was told that the company could issue bonds at par value of $100 with a 6% coupon rate.  She was advised to consider a capital structure in the range of 70% equity and 30% debt, consistent with some of the leading companies in the industry.  She especially noted a warning from several of the banks that if the company went beyond 30% debt, its bonds would be assigned a lower credit rating than typical for other companies in the industry, and require a higher coupon rate because the possibility of financial distress and associated costs would rise sharply.

Tania decided to examine this capital structure decision assuming efficient markets, perpetual cash flows, and applying a similar analysis to that developed by Modigliani and Miller.  This would serve as a foundation for further investigation that would also take into account company-specific factors.

The company is subject to a corporate tax rate of 30%

  1. If MacPherson Development wants to maximise its total market value should Tania recommend it issue debt or equity to finance the Port Adelaide project?  Explain. (8 marks)

  2. What is the current market value of the company’s equity under its all equity capital structure? (6 marks)

  3. If the company decides to issue shares to fund the Port Adelaide project, what would be the NPV of the project?  What would be the new price per share after an announcement that the company would proceed with this project?  How many shares would the company have to issue to raise $85,000,000?  How many shares would the company have outstanding after the capital raising? (10 marks)

  4. Assume the company decides to retain its all-equity capital structure.  What will be the value of its equity immediately after the issue of shares to raise the $85,000,000? (10 marks)

  5. What would be the total value of the company immediately after the issue of bonds if debt is used to raise the required capital?  What would be the price per share? (12 marks)

  6. What would be the company’s WACC under the levered structure? (6 marks)

  7. What conclusions can Tania draw from the above analysis about the impact of a change in capital structure?

 

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  • Uploaded By : Alex Cerry
  • Posted on : April 25th, 2019
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