Part 1:
Sovereign Mines is a large mining firm considering the purchase of a new drilling machine. The machine will be used to drill for iron ore at an existing mine site in Australia. Sovereign Mines is one of the leading producers 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 require installation costs of $5,000. Machine A can run for six years at which time it will have a salvage value of $5,000. The machine will require initial working capital of $80,000 and will produce annual revenues of $150,000 and cash operating expenses 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 requires installation costs of $4,000. The machine will require initial working capital of $70,000 and will generate annual revenues of $155,000 and cash expenses of $95,000. Its expected salvage value at the 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 the 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 expected 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 choose and why (show all working). You need to report to the Board of Directors on the viability of this investment, including a clear explanation of the cash flows under analysis. The Board consists of a cross section of smart people but some have little or no finance training so your report needs to fully describe and justify
the evaluation techniques and your final decision.
Part 2:
Discussion around government funded maternity leave programs has led you to believe that taxes will increase before the project can be implemented. How does your analysis in part 1 change if the 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 need to find a proxy company that reflects the profile of your firm. You need to identify a suitable proxy and collect the required data to empirically estimate a proxy beta that 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 expected equity risk premium.
You write a report to the board outlining your analysis of the choice of Machine using the proxy discount rate. In your report you must fully discuss and justify the data you acquired, 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 may impact on the investment decision. To alleviate your fears (and those of the board) you run a sensitivity analysis to see how changes in the beta estimate affect your investment choice. You include this analysis in your report to the board and discuss the implications of you analysis.