Essay Instructions: Please answer the below finance questions.
Please note use the textbook ( Ross, SA, Westerfield, RW & Jaffe, JF 2010, Corporate finance , 9th edition, McGraw-Hill/Irwin) or previous editions for your reference. Also finance formulas to be either shown in arithmetic or annuity table formats.
Question One:
Globally, the bond market serves as the primary channel for debt funding of large corporations and government
bodies.
TerraVerdi (TV) is a plastics company that diversified, more than a decade ago, into the manufacture of artificial grasses and lawns. These products are manufactured from recycled plastics.
During this time, the company grew rapidly and has gained international prominence in its field. TV grew from its origins in Italy to having subsidiary operations in ten other countries and agents representing the company in a further 27 countries.
The company was family owned during the above period and the firm relied, for much of its finance, on support from the company?s bankers, Banco Blanco. Accordingly, the firm?s founders have a strong sense of loyalty to the bank. At present, the bank loans total ?1.1 billion principal and have an average interest rate of 8.5% p.a. and average maturity of 5 years.
However, the company listed on the stock exchange two years ago and the new CEO ? who is very profit-oriented ? intends to propose to the board that the company should issue bonds to replace the bank loans. Accordingly, the CEO has requested that you write a few brief points that he should take to the board in support of his proposal.
Required:
a) Explain briefly why the company would most likely need a bond rating and what it would have to do to get that
rating. (a few paragraphs)
b) Assume Principe Investment Bankers (PIB) have expressed the opinion that TV would most probably be able to obtain an A- rating on the assumption that they were to issue no more than ?1 billion of debt. An extract from the current AAA yield curve is as follows:
1 Year = 6%, 2 years = 6.5%, 5 years = 7.0% & 10 years = 8%
On the basis that A- yields differ by about 1% p.a. from AAA yields, show approximately the amount of the annual interest-saving benefits (in Euros, ?), other things being equal, by replacing the term loans with bonds. (A simplified, arithmetic computation will suffice)
c) If all issue costs total ?20 million for a ?1 billion par issue (at the relevant yield you determined in part (b)), what effect would this have on your answer in (b)? (Assume coupons are paid half-yearly)
Question Two: (50 marks)
Adlcorp Limited Steel Division is considering a proposal to purchase a new machine to manufacture a new product. The new machine will cost $1 million. The machine has an estimated life of three years for accounting and taxation purposes. Estimated salvage value at the end of three years is $100,000 in today?s dollars. The tax rate is 30 percent and is payable in the year in which profit is earned. An investment allowance of twenty percent
is available.
The purchase can be fully financed by debt, which is available at the firm?s normal rate of 10 percent. One hundred percent financing is available with principal and interest payments at the end of each year for three years of $402,115. The firm does not intend to change its target debt/equity ratio.
Projects of this type and risk normally have a nominal cost of capital of 12.27 percent and a real cost of capital of 9 percent for the time horizon involved. The Steel Division normally uses a weighted average cost of capital of 13.3 percent (including inflation).
Addition net working capital of $60,000 is required immediately to support the project. Assume that this amount (in today?s dollars) is recovered at the end of three years.
The new product will absorb $50,000 of allocated head office administration costs each year. This is in accordance with the firm?s policy of allocating all corporate overhead costs to divisions. Extra marketing and administration expenditure of $40,000 per year will be incurred ($40,000 for year one increasing by the inflation rate of three percent per annum).
An amount of $30,000 has been spent on a pilot study and market research for the new product. The figures provided above are based on this work.
Projected sales for the new product are 30,000 units at $110 per unit for year one. Units sold will rise at the rate of 3,000 per year over the next two years. Cash expenses are estimated to be 80 precent of sales. Prices determining revenue and expenditure will increase at the inflation rate of 3% pa.
Except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated).
Required:
a) Calculate the NPV. Is the project acceptable? (Assume prime cost depreciation for tax purposes).
b) Explain your calculation of relevant cash flows, justifying your calculations and approach.
c) Defend your choice of discount rate.
