FUNDAMENTALS OF FINANCE - ASSIGNMENT

PART 1- Assignment REQUIREMENTS

You work in the Finance division of the North Melbourne Manufacturing Company Ltd. The company is in the process of deciding whether or not to purchase a new welding machine. Your company's Chief Financial Officer has asked you to prepare a report on this potential project, and to make a recommendation as to whether or not the company should proceed with the project.

Your report should include the following:

1. Calculation of the company's Weighted Average Cost of Capital.

2. Explanation of the circumstances in which it would be appropriate to use the company's WACC as the discount rate in evaluating the project.

3. Calculation of the Net Present Value of the project.

4. Calculation of the Internal Rate of Return of the project.

5. Calculation of the Payback Period of the project.

6. Explanation of which of these methods should be used to evaluate the project.

7. Your recommendation as to whether or not the project should proceed.

PART 2- COMPANY DATA

The following data should be used in calculating the company's Weighted Average Cost of Capital.

Capital Structure

Corporate Bonds

- The company's debt consists of corporate bonds with a face value of $1,200,000.

- The bonds mature in 10 years.

- They pay an annual coupon at a coupon rate of 5.9% p.a.

- Standard and Poor's have given the company a debt rating of BB+.

Preference Shares

- The company' has 800,000 preference shares on issue.

- The preference shares pay an annual dividend of $0.63.

- They are currently trading for a price of $10.99.

Ordinary Shares

- The company' has 1,300,000 ordinary shares on issue.

- The ordinary shares have a beta of 1.2.

- The shares are expected to pay a dividend of $0.66 next year. The dividend is expected to grow at a rate of 7% for the following 4 years, and after that it will grow at a constant rate of 2% p.a. in perpetuity.

Other Information
- The long term market risk premium is 7.9% p.a.

Online Information (Instructions for obtaining this information are contained in Part 3.)

- The company tax rate is %.

- The credit spread for North Melbourne's bonds is yet to be determined - see Step 4. The 10-year risk-free rate is yet to be determined - see Step 4.

PART 3 - ONLINE DATA

Follow the instructions below to locate online data that you will need for your Assignment.

1. Find the Australian company tax rate for the 2014/15 tax year. Go to www.ato.gov.au

In the Search box at the top of the screen, enter 'Company tax rate' and click the magnifying glass. Click on the item in the list of search results that says 'Company Tax I Australian Taxation Office'. Enter the company tax rate for the 2014/15 tax year (as a percentage) in Box A below.

Australian company tax rate (2014/15) - Box A

2. Find the credit spread on 10-year bonds with a BB+ credit rating.

Go to www.bondsonline.com

Click on 'Today's Markets' from the menu on the left-hand side of the screen. Under the subheading 'Corporate Bond Spreads', click on the link 'US Corporate Debt spread data'. Scroll down to the table entitled 'Reuters Corporate Spreads for Industrials'.

Credit spreads are expressed in basis points, where a basis point is 0.01%. A credit spread is the amount we need to add to the risk-free rate to find the yield on a bond with a given credit rating (or debt rating). Current credit spreads are only available for a fee - the ones you see are out of date, but we will use them as if they are current. Australian credit spreads (current or historic) are not obtainable without paying a fee, so we will use US corporate credit spreads and we will assume that they are applicable to Australia. We will add them to the Australian risk-free rate (see Step 3 below), rather than the US risk-free rate.

Determine the credit spread for North Melbourne's bonds and enter this value (in basis points) in Box B below.

Credit spread for North Melbourne's bonds - Box B bp

3. Find the yield on 10-year Australian Treasury bonds.

Go to www.rba.gov.au

Click on 'Statistics' near the top of the page, and then, under the subheading 'Economic and Financial Statistics', click on 'Interest Rate? Click on the 'XLS' link to open the spreadsheet containing 'Indicative Mid Rates of Commonwealth Government Securities - 2013 to Current'.
This spreadsheet contains daily yield data for Australian Treasury bonds on issue on a given date. Row 3 contains the maturity date of each bond. Search along Row 3 to find the column containing the bond that is closest to maturing 10 years from now. Then go down that column to find the last value in the column. The value you see is the current yield on 10-year Australian Treasury bonds, which we will use as the risk-free rate in the Capital Asset

Pricing Model. The date in Column A, at the start of that row, is the most recent date (the date closest to today) for which yields are available, Enter the 10-year risk-free rate in Box C below (as a percentage).

In the box below Box C, from the drop-down menu, select the applicable date for the yield that you have obtained (the date in Column A of the spreadsheet). After you complete this page, include a copy of Part 1 in your Assignment submission.

10-year risk-free rate - BOX C

Enter the applicable date for the above yield (the date in Column A of the spreadsheet)

Because North Melbourne's bonds also mature in 10 years, you will add the credit spread for the company's bonds to the 10-year risk-free rate to determine the before-tax cost of the company's bonds.

PART 4 - PROJECT DATA

The following data should be used in evaluating the oroiect to ourchase a new equipment.

A feasibility study has been undertaken into the purchase of the new welding machine. The cost of preparing the feasibility study was $3,000.
The equipment will cost $21,000, is expected to have a working life of 4 years, will be depreciated on a diminishing-value basis to a book value of zero, and is expected to have a salvage value of $2,000 at the end of 4 years.

The new equipment will improve efficiency and result in increased revenue of $11,800 in its first year of operation, but because of reduced efficiency from normal wear and tear, revenue will decrease by 7% per year for the remaining 3 years of the equipment's life.

Excluding maintenance, all other costs from operating the equipment will be $2,100 per year Maintenance costs will amount to $1,400 in the equipment's first year of operation, and will then increase by $100 per year for the remaining 3 years of the equipment's life.

The equipment will be installed in a building that is owned by the company, but currently is not being used. If the project does not proceed, this building could be rented out for $1,100 per year.

The equipment will require additional net working capital of $1,700.

7he net working capital will be recovered in full after the equipment is sold at the end of its working life.

Management has indicated that the maximum acceptable Payback Period for the company is 5 years. They also want ALL cash outflows at the beginning of the project (including any increase in net working capital and any other costs) to be recovered within the maximum acceptable payback period of 5 years.

APPENDIX - INTERNAL RATE OF RETURN

Although you are not required to calculate the internal rate of return in the final exam, it is important to understand what the IRR is and how the IRR decision rule is used to evaluate projects. You therefore need to calculate the IRR of the project in this Assignment. Shown below are instructions for doing this in a spreadsheet. It is also possible to do so with a financial calculator, but the steps will vary depending on the calculator.

Shown above, in cells E9 to 19, are the typical free cash flows for a 4-year project. To calculate the Internal Rate of Return for these cash flows, enter the following into any cell: =IRR(E9:19). Try it in the following cell. If you do it correctly you should get an answer of 5.54%.