Question 1: Capital Budgeting Task
You are helping Initech with its capital budgeting decisions. The company is a producer and wholesaler of electronic parts, has a 14% cost of capital and is subject to a 30% tax rate. There are two major proposals on which Initech would like your advice.
1. The device part project
Initech is considering whether it should expand into production of a part for a new generation of mobile devices. Trends suggest these devices and their parts will offer high growth in the early years of a 5-year life cycle.
The new plant and equipment needed to produce the part will cost $800,000, which the business will depreciate for tax purposes using a prime cost rate of 10% per annum. When the project is wound up at the end of five years, the general purpose equipment is expected to be sold for an estimated $200,000.
Sales in the first year are expected to be $4,000,000, increasing at a high rate of 10% in the second and third years and then falling by 15% per year for the last two years of the project as demand declines due to competing new technologies. Consultants called in previously by Initech, who were paid $75,000 in fees, estimated that variable costs for the project will be 50% of its revenues.
Building rental, fixed salaries and other fixed costs directly related to the project are expected to be $1,500,000 in the first year and increase by 2% per year thereafter. The investment in net operating working capital related to the project is expected to be 10% of the following year's sales revenues. This investment will be recovered by the end of the project. It is also thought that the project will encourage additional after tax profits of $150,000 per year for Initechs' existing part range.
2. The conveyer system
Initech needs to install a conveyer system as soon as possible because the existing system, which has no scrap value, is beyond repair. Three different systems are being considered. The first, System A, is the same type of system as the old one - just a newer model. It will last 10 years and cost $40,000 to purchase and install. The second, System B, will last 10 years and cost $55,000 to purchase and install. The third, System C, will last 20 years and cost $130,000 to purchase and install. None of the systems will have any expected salvage value but all will be replaced at the end of their lives. After examining all costs, the net cash outflows for each system are: $13,000 per year for System A; $9,000 per year for System B; and $1,400 per year for System C.
Requirements and marking criteria
Provide Initech with a memo that provides your recommendations on the two proposals. Your memo should also include details of your analysis and briefly explain and justify your chosen methods and any assumptions made. Table format for presenting figures is preferable.
Twelve marks will be allocated to analysis of the device part project and six marks to analysis of the conveyer system. Marks for each will be awarded for demonstrated understanding of the issues through: justification of chosen analytical techniques, correct application of those techniques, and appropriate and insightful conclusions and recommendations.
Question 2: Company analysis
For this question you are required to further analyse the ASX listed company assigned to you for Assignment 2.
a) Briefly describe a likely "average" risk capital budgeting project for the company. Consider its possible life, cash flow pattern and investment size relative to the company. Also hypothesise the variables to which NPV might be most sensitive and would therefore need the most focus in project analysis. No quantitative analysis is needed to answer this question. Focus on qualitative factors. If the company has several business divisions, choose one for this question.
b) Assess the working capital management of your assigned company, focusing on its cash conversion cycle for each of the 30 June 2015 and 30 June 2016 financial years. Incorporate the company's context within your evaluation and compare with a competitor or other relevant benchmark. As in Assignment 2, use DatAnalysis to access your assigned company's financial data.
Question 3: Short-term financing
No additional research or data is necessary in answering this question. Simply apply your knowledge from the unit learning materials.
In its 2016 Annual Report, Telstra Corporation Limited stated that (p. 112):
Our commercial paper is used principally to support working capital and short term liquidity.
a) What does the use of commercial paper suggest about the credit risk of Telstra?
b) What asset financing policy does the quote above suggest Telstra may follow? Justify your answer and outline the benefits of that policy in comparison with alternative policies.