Assignment
Part A: Capital Budgeting Background:
This case is fictional and bears no relation to actual practice at Mars Australia New Zealand
Mars Australia and New Zealand manufacture a range of fast moving consumer goods (FMCG) including pet food and pet care products, chocolates, confectionery, ice cream, and a variety of food products and supplements. These products are largely sold through supermarkets and specialty retailers. The Head Office for Mars Australia is in Albury Wodonga on the New South Wales - Victorian border. The company opened its first manufacturing facility in Albury Wodonga in 1966. Since then they have expanded their manufacturing footprint to include other sites in regional Australia and New Zealand.
In the past two years Mars have launched their ‘Sustainable in a Generation' plan which reflects their plan to "grow in ways that are good for people, good for the planet, and good for our business" (Mars, 2019). A key focus to achieve these a goals is to focus on more efficient use of water and energy resources.
Mars has a large confectionery factory in Ballarat which first opened 40 years ago in 1979. Confectionery manufactured in Ballarat includes the eponymous Mars Bar, Snickers, Maltesers, M&Ms, Bounty and Dove chocolates. The factory that manufactures the ‘Nutty Nut' chocolate bar has not undergone a major refurbishment in the past 20 years and product managers are concerned that the cost of operating and maintaining old technology has impacted the cost and quality of the product.
Problem:
A full product market research analysis of the ‘Nutty Nut' brand has been undertaken by external consultants at a cost of $500,000. The consultants found that by improving the quality of the product and lowering the cost, Nutty Nut can potentially become a market leader.
Facilities management have produced the following budget on a factory refurbishment and technology upgrade which will cost an initial capital outlay of AUD$17.5 million. The existing plant and equipment will be sold for salvage and is expected to have a salvage value of $400,000. The existing equipment has a zero written down value in the accounts having been fully depreciated over its life. The upgraded facility will be ready for use at the commencement of the 2019-20 financial year. The upgrade will result in a 20% cut in power usage which represents a saving in electricity costs of $25,000 per week and an annual saving of $600,000 in water costs. The use of advanced robotics mean that less direct labour is required and labour savings and on-costs will amount to $2.5 million per annum. It is estimated that the cost of training staff to operate the new production line will amount to $750,000 which will be incurred before the new facilities come on-line. This cost is expected to be recorded as labour costs in the 2019 financial year. Extra maintenance of the new information technology (IT) and robotics is estimated to cost approximately $4,000 per week.
The new production facility will be depreciated on a straight line basis over its 10 year life cycle to zero. Because of anticipated technology changes the production facility is expected to have a salvage value of $1 million at the end of 10 years. Mars are an international company and pay Australian tax at the rate of 30% on profits. The capital budgeting analysis should be conducted on an after tax basis. For the purpose of this analysis, tax should be recognised in the same year as the cash flow generating activity.
The upgrade will increase the production capacity of the original factory by 50% and all costs other than Raw Materials will now be fixed. Whilst the proposed refurbished facility will achieve many facets of the Mars sustainability agenda the project must still pass the company's international benchmark for capital investment of achieving a return of 20%.
(i) Prepare an excel spreadsheet calculating whether this product will satisfy the investment parameters set by Mars. For the proposed ‘Nutty Nut' capital investment calculate the following (using formula and worked out solutions):
? After-tax cash flows
? Payback period
? Net present value
? Profitability index
(ii) You are asked to present a report on your findings regarding the upgrade proposal. Make a recommendation to Management on whether they should proceed with the upgrade or not. Explain the criteria on which you have based your decision and ensure that you include an analysis of the strategic implications of some of the cost assumptions which underpin the budget.
(iii) The closure of a Mars product line at their Ballarat site has left the company with an unoccupied manufacturing facility. Two projects have been proposed to use the space and the following estimates of the present value of the competing project cash flows have been made:
Chocolate Ice cream
Net Present Value $25,000 $32,000
Estimated useful life 6 years 9 years
(a) Explain how financial managers may evaluate two mutually exclusive projects that are of unequal lives.
(b) Assuming a required rate of return on projects of this type of 12%, decide which project you think the company should accept (show all workings).
Part B: Cost of Capital
Cloudstreet Ltd is an Australian firm which is publicly-listed on the ASX. The company has a long term target capital structure of 60% Ordinary Equity, 10% Preference Shares, and 30% Debt. All of the shareholders of Cloudstreet are Australian residents for tax purposes. To fund a major expansion Cloudstreet Ltd needs to raise a $120 million in capital from debt and equity markets.
Cloudstreet Ltd's broker advises that they can sell new corporate bonds to investors for $1030 with a coupon of 6% and a face value of $1,000. Issue costs on this new debt is expected to be 1.5% of face value. The firm can also issue new $100 preference shares which will pay a dividend of $8 and have issue costs of 5%. The company also plans to issue new Ordinary Shares at an issue cost of 3%. The ordinary shares of Cloudstreet are currently trading at $7.50 per share and will pay a dividend of $0.40 this year. Ordinary dividends in Cloudstreet are predicted to grow at a constant rate of 4% pa.
a. (i) Calculate how much debt Cloudstreet will need to issue to maintain their target capital structure.
(ii) What will be the appropriate cost of debt for Cloudstreet.
b. (i) Calculate how much Preference Share equity Cloudstreet will need to issue to maintain their target capital structure.
(ii) What will be the appropriate cost of Preference shares for Cloudstreet?
c. (i) Calculate how much Ordinary Share equity Cloudstreet will need to issue to maintain their target capital structure.
(ii). What will be the appropriate cost of Ordinary Equity shares for Cloudstreet?
d. Calculate how the Weighted Average Cost of Capital for Cloudstreet Ltd following the new capital raising.
e. Cloudstreet Ltd has a current EBIT of $1.5 million per annum. The CFO approaches the Board and advises them that they have devised a strategy which will lower the company's cost of capital by a full 1%. How will this change the value of the company? Support your answer using theory and calculations.
Format your assignment according to the following formatting requirements:
1. The answer should be typed, double spaced, using Times New Roman font (size 12), with one-inch margins on all sides.
2. The response also includes a cover page containing the title of the assignment, the student's name, the course title, and the date. The cover page is not included in the required page length.
3. Also include a reference page. The Citations and references should follow APA format. The reference page is not included in the required page length.