Part 1:
Sovereign Mines is a large mining firm considering purchase of a latest drilling machine. The machine will be employed to drill for iron ore at an existing mine site in Australia. Sovereign Mines is one of the leading manufacturers of iron ore in Australia. In order to narrow their drill machine search Sovereign Mines commissioned a market analysis at a cost of $5000 (yet to be paid). The study identified two candidate machines.
Machine A costs $100,000 and will necessitate installation costs of $5,000. Machine A can run for six years at which time it will have the salvage value of $5,000. The machine will necessitate initial working capital of $80,000 and will produce annual revenues of $150,000 and cash operating expenditures of $102,000. The salesman for Machine A is offering a loan at 10% per annum compounded monthly for the 6 year life of the machine.
Machine B can be purchased for $150,000 and necessitates installation costs of $4,000. The machine will necessitate initial working capital of $70,000 and will create annual revenues of $155,000 and cash expenses of $95,000. Its anticipated salvage value at end of its ten-year life is $2,000.
The tax rate for the corporation is 30% and the company policy is to depreciate assets (including installation costs) to zero using straight line method. Sovereign Mines estimates the covariance between the ASX200 and Sovereign Mines to be .06. The standard deviation of ASX200 returns is 25% and the standard deviation of Sovereign Mines is 35%. The anticipated return on the ASX 200 is 12% and the risk free rate is 7%. The firm is 100% equity financed.
Which Machine should Sovereign Mines select and why (show all working). You need to report to the Board of Directors on viability of this investment, including a clear explanation of cash flows under analysis. The Board includes a cross section of smart people but some have little or no finance training so your report requires completely describe and justify the evaluation techniques and your final verdict.
Part 2:
Discussion around government funded maternity leave programs has led you to think that taxes will increase before the project can be implemented. How does your analysis in part 1 change if tax rate is increased to 40%?
Part 3:
As the Chief Investment Officer you are concerned that the values applied to estimate the discount rate have not been updated for several years. As Sovereign Mines is not a publicly listed company you require find a proxy company which reflects the profile of your firm. You need to find out a suitable proxy and collect the needed data to empirically estimate a proxy beta which can be applied to Sovereign Mines taking care to adjust for changes in leverage. You then use the beta to estimate an appropriate discount rate for Sovereign Mines. You will also need to collect data to estimate the risk free rate and the anticipated equity risk premium.
You prepare a report to board outlining your analysis of the choice of Machine using proxy discount rate. In your report you should completely discuss and justify the data you incurred, the time period and data interval used and the estimation procedure you applied.
Part 4:
You are having second thoughts about your choice of Proxy Company and are concerned that a wrong choice might impact on the investment decision. To alleviate your fears (and those of the board) you run a sensitivity analysis to see how changes in beta estimate affect your investment choice. You include this analysis in your report to the board and discuss the insinuations of you analysis.