Acc00716 Finance For The Incremental Assessment Answers
Questions:
Question 2: Short-term rinancing
b) Why financing policy does the quote above suggest Telstra may follow? Justify your answer and outline benefits of that policy in comparison with alternative policies.Â
Answers:Â
Initech Company is a producer and wholesaler of electronic parts. The cost of capital of the company is 14% and the tax rate is 30%. There are two major proposals on which respective suggestions needs to be extended based on available techniques in capital budgeting.
Device part project
In this proposal Initech expands the production line especially for the new generation of mobile devices. The necessary data and information regarding the proposal is listed below:
Useful life of project = 5 years
New plant and equipment purchase and installation cost =$800,000
The business would depreciate for tax purpose with a cost rate = 10% per annumÂ
When the project is wound up at end of the project life of 5 years , the general purpose equipment is expected to sell = $200,000
Sales (revenue) in the first year = $4,000,000
The sale will increase in second and third year = 10%
Then the same will decrease in the last two years = 15%
Payment to Consultant = $75,000 (would not be considered because the fee is already paid to the consultant and hence in capital budgeting terms is a sunk cost) (Damodaran, 2010).
Variable costs for the project are pegged at half of the incremental revenues generated.
Building rental, fixed salaries and fixed cost (in the first year) = $1,500,000 (increase by 2% per year)
Annual operating capital requirement at t = 10% of expected revenues in (t+1)
Additional after tax profit generate for Initech =$150,000 per year
Now,
- Accumulated depreciation
- Book value for the general purpose equipment (after 5 year) = 800,000 – (5*80,000) =$400,000
- Total loss amount (because the book value of general purpose equipment is higher than the income earned from the sale) =
- After tax salvage value (Beck et. al., 2013).
Assumptions
- The cash flows for all the transaction are incurred at the end of the year and are in the form of lump sum form. Further, all the general purpose equipment would liquidate by the end of the project.
To decide whether Initech should invest in the device part project, NPV computation would be carried in excel with the help of given information and assumptions (Brealey, Myers and Allen, 2012).
It can be seen that the NPV for the given device project proposal comes out positive ($983,362). Therefore, it would be advised to the Initech company that they should make an investment in the device project proposal. The selection of the project would be profitable to the shareholders of the company (Troughton et. al., 2012).
Conveyor System
A new conveyer system is required to be installed by Initech because the current system cannot be repaired. The three different systems (A, B & C) are being considered by the company.
To decide which system company needs to select for their system is determined via equivalent annual annuity computation. The system which results in maximum equivalent annual annuity would be considered most favourable system to replace the current system. It is because from the information it can be seen that the useful life of the system are not equal and hence fair comparison metric would not be NPV as the project having a higher life would have an edge over others. Therefore, equivalent annual annuity would be used (Brealey, Myers and Allen, 2012).
|
Particular |
System A |
System B |
System C |
|
Useful life (year) |
10 |
10 |
20 |
|
Tax rate (%) |
30 |
30 |
30 |
|
Cost associated with the system purchase and installation ($) |
40,000 |
55,000 |
130,000 |
|
Per annum cash flow($) |
-13,000 |
-9,000 |
-1,400 |
|
Cash flow (after tax) ($) |
=-91,000 |
= -63,000 |
= -980 |
|
NPV ($) |
= = -87,467 |
=136,491 | |
|
EAA ($) |
= -20, 608 |
 The highest value of EAA has been computed for system A. Therefore, Initech should consider system A in regards to replace the current system (Beck et. al., 2013).Â
Typical cash outlay = $ 7 - $ 9 million
Mode – Buyout an existing hotel
Cash flows – High outflow at the beginning spent on acquisition and rebranding the hotel. Once upon considering the strong brand name, it might be expected that cash flows would turn out to be positive within some months based on season and other factors such as location.
Key Parameters – Acquisition Price, Location, Economic conditions, Staff Costs, Cost of Capital, Room Rental, Cash Flow Timing
While all the above do influence the project NPV, some of them are very critical. This includes the acquisition price as the valuations should not be stretched and turnaround cost must also be considered while acquiring. Further, economic conditions and location are other two aspects which are especially critical as these would determine the occupancy and hence the project NPV (Damodaran 2010).
As Mantra has presence in travel business besides other business, comparison has been performed with another listed player named Helloworld Limited. Since the business is such that inventory and payables do not exist, hence the turnover in receivable period essentially become the cash conversion and is summarised below (Morningstar, 2017a; 2017b)
The above figure clearly indicates that working capital management has improved for Mantra since there has been a dip in the cash conversion cycle which would essentially lower the quantum of short term financing required as working capital. The comparison with Helloworld is not fair in entirely as Mantra focuses on multiple businesses with travel agency being one of them. For the competitor HelloWorld Limited, there seems to be a deterioration in the management of working capital as the receivables turnover period has increased unlike Mantra for whom it has decreased (Troughton et. al., 2012).
The quote drawn from the financial statements of Telstra (which is a Telecom major) reflects that company has raised short term financing through commercial paper. This apparently communicates that the credit risk associated with the company is minimal as commercial paper is unsecured debt which only creditworthy companies having negligible default risk tend to avail (Brealey, Myers and Allen, 2012).
The quote drawn from the financial statements of Telstra highlights that commercial paper is being used only for short term financing which directly implies for long term financing, alternative financing strategies having higher maturity period would be deployed. Thus, the company does not rely on aggressive or conservative financing strategy but rather tends to indulge in matching of maturity which is the best strategy (Damodaran, 2010). This is because an aggressive strategy based on short term financing would be unsuitable for a telecom major with capital investment project spanning into many years. Further, a conservative strategy comprising of long term financing while suited for long term financing would lead to higher costs if used for financing working capital (Beck et. al., 2013).
References
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N. (2013)Â Fundamentals of corporate finance. London: Pearson Higher Education
Damodaran, A. (2010) Applied corporate finance: A user’s manual. 3rd edn. New York: Wiley, John & Sons.
Morningstar (2017a), Mantra Limited, [Online] Available at https://financials.morningstar.com/ratios/r.html?t=MTR®ion=aus&culture=en-US [Assessed May 14 2017]
Morningstar (2017b), HelloWorld Limited, [Online] Available at https://financials.morningstar.com/ratios/r.html?t=ID9 [Assessed May 14 2017]
Brealey, R.A., Myers, S.C. and Allen, F. (2012)Â Principles of corporate finance. 2nd edn. New York: McGraw-Hill .
Troughton, G.H., Fridson, M.S., Scanlan, M. and Clayman, M.R. (2012)Â Corporate finance: A practical approach. 2nd edn. New York: John Wiley & Sons.
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