EDITH COWAN UNIVERSITY
FBL5030
FUNDAMENTALS OF VALUE CREATION IN BUSINESS
SEMESTER 2, 2015
ASSIGNMENT 2 – FINANCE
Case Study in Finance – Nova Tractor Corporation
SUBMISSION REQUIREMENTS
? Due by 5pm Friday 30th October (week 13) through Turnitin
? MUST include the ECU assignment cover page (provided on our BB website). Please note that if an assignment cover sheet is not included your assignment will not be graded.
? The assignment must be submitted:
? as one document, and
? in one copy by the nominated group leader (if completed in a group)
CONTRACT INFORMATION
? If you complete the assignment in a group you should:
? submit a completed and signed FBL5030 assignment contract in person (on campus students) or via email (external students) before starting your teamwork
? submit an assignment peer review form in person (on campus students) or via email (external students) after submitting the assignment
ADDITIONAL INFORMATION
? Your assignment should be in the form of business report (please refer to the document provided). Your report should include:
a) Cover / Title page
b) An Executive Summary (word limit 300)
c) An introduction (not more than 150 words)
d) Findings and Discussion – Answers to the given questions written in the body paragraphs, with appropriate headings, subheadings, etc. This analysis should not exceed 1,200 words
e) A recommendations (not more than 200 words)
? Use a word processor to prepare assignment on A4 paper. Handwritten assignments will not be accepted
? Choose a legible font face and size (e.g. Times New Roman 12 or Arial 11 would be sufficient) and double-spaced your lines
? Aim for a professional level of document presentation and formatting
? Do not include a reference list in this assignment
? Support your answers given in the body of the report with relevant Excel workings and tables placed in the appendices. You will do this by copying all Excel tables and pasting them as a picture / screenshot in your Word document. This minimises the chance of a viewing error after uploading on Turnitin
? Observe the due date strictly. Extensions can only be granted with supporting documentation (e.g. medical certificate or court summons).
CASE STUDY IN FINANCE – NOVA TRACTOR CORPORATION
Nova Tractor Corporation owns and operates a transmission and axle plant which manufactures more than 50% of the transmissions and axles used in the complete line of tractors and harvesting equipment offered by Nova to the agricultural industry. With an extensive machining processes performed on the steel parts for the final transmission and axle assembly, a very large amount of steel shavings and bulky steel scrap is generated in this plant.
The unprocessed steel scrap is sold as a by-product of the manufacturing operation to various firms involved in the recycling process. The executive committee is currently evaluating whether to process the scrap into different grades and types of usable steel. Using different models of chip crushers, the scrap is grinded and compressed into either “rough” or “fine” scrap. The fine scrap fetches a higher market price than the rough scrap.
Nova has to decide whether to invest in the higher-cost chip crusher (HCC) to produce fine scrap or the lower-cost chip crusher (LCC) to produce rough scrap.
As a financial analyst of the company, you have gathered relevant purchase prices and operating costs of the two chip crushers from the supplier of the chip crushers and the marketing and production staff.
Key estimates of financial data for the two machines are shown in Table 1.
Table 1: Key Estimates of Financial Data
HCC LCC
Purchase Price $500,000 $400,000
Life (years) 6 4
Depreciation (reducing balance method) 40% p.a. 35% p.a.
Residual value at the end of the useful life $45,000 $25,000
Annual processed scrap revenue $580,000 $520,000
Working capital (% of scrap revenue) 10% 10%
Annual Operating Costs
- Overheads $140,000 $105,000
- Salaries $110,000 $80,000
- Marketing $58,000 $52,000
The estimates for annual operating costs include the following items:
i) The overheads include direct operating expenses incurred in the production of the fine or rough scrap and a fixed amount of $30,000 per annum to cover the Head Office overheads.
ii) Salaries for LCC represent the costs of employing two new machine operators at a salary of $40,000 per annum each. For HCC, the company would only need to employ a new machine operator at a salary of $40,000 per annum and the second, who earns $70,000 per annum, will be transferred from the axle assembly plant. If the transfer is not required, the second operator from the main plant would have been laid off with a redundancy payment of $50,000.
iii) The marketing cost is based on the standard allocation of the new investment towards group advertising expenses, which is 10% of annual processed scrap revenue. It has been estimated that the additional group advertising required promoting the sales of fine or rough scrap is only $40,000 per year.
Nova is a private company, soundly financed and consistently profitable. Cash and deposits are not sufficient to buy the chip crusher. However, Mr Jack Murray, the Chairman of Nova, is confident that the cost of the chip crusher could be financed with medium-term debt.
Preliminary discussions with Nova’s bankers led Mr Murray to believe that the firm could arrange a 12% 4-year term loan of $400,000 or 6-year term loan of $500,000 for LCC and HCC, respectively. The terms for both loans are repayment of fixed annual interest expense in advance and the principal owing at maturity. The company’s tax rate is 30%, and its nominal after-tax cost of capital is 15% per annum.
The accountant, Mr Peter Smith, pointed out to you that the revenue figures do not take into consideration the scrap sales that Nova would generate if the company did not buy either machine to process the scrap. He has estimated that the current unprocessed scrap would generate a net income of $120,000 per year.
Production facilities for the steel scrap would be set up in an unused section of Nova’s main plant. The section of the plant where the steel scrap production would occur has been unused for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, Nova spent $80,000 to rehabilitate that section of the main plant.
Smith believes this outlay, which has already been paid and expensed for tax purposes, should be charged to the steel scrap project. His contention is that if the rehabilitation had not taken place, the firm would have to spend $80,000 to make the site suitable for the steel scrap project. As the section of the plant has been rehabilitated, it could fetch a rental income of $36,000 per year.
Murray wanted to see some type of risk analysis on the project as it might be profitable, but what are the chances that it might turn out to be a loser. You met with the marketing and production managers to get a feel for the uncertainties involved the cash flow estimates. After several sessions, they concluded that there was little uncertainty in any of the estimates except for sales, which could vary widely. Past contracts agreed upon with several dealers indicate the future revenues from the sales of processed steel scrap could be higher or lower than the marketing staff had anticipated, depending on the market demand. In their opinion, the revenue projections for both LCC and HCC could deviate from its estimated values given in Table 1 by plus or minus 20%.
You also discussed with Andrew Frost, Nova’s director of capital budgeting, on the risk inherent in Nova’s average project and how the company typically would adjust for risk. Frost told you that, the firm has been adding or subtracting 3 percentage points to its 15% overall cost of capital to adjust for differential project risk. When you asked about the basis for the 3-percentage point adjustment, Frost stated that it apparently had no basis except the subjective judgement of John Newton, a former director of capital budgeting who was no longer with the company. Therefore, may be the adjustment should be 2 percentage points or may be 5 percentage points.
QUESTIONS
1. Prepare the cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) for each chip crusher using the information given in the case.
Which of the following items should be included as incremental cash flows in the table? Give reasons for individual items and list clearly your assumptions in deriving the figures.
a) Yearly interest expense on the fixed-term loan for each machine;
b) Working capital investment which is 10% of annual scrap revenue;
c) Annual operating costs (i.e. overheads, salaries and marketing) for each machine;
d) The $80,000 that was spent to rehabilitate the plan;
e) Net income of $120,000 per year from the sales of unprocessed scrap;
f) Rental income of $36,000 per year.
2. Which chip crusher (HCC or LCC) would you recommend Nova to purchase based on the payback period (PP), internal rate of return (IRR), net present value (NPV) and equivalent annual value (EAV) methods?
[Assume the company is able to invest in both chip crushers on the same terms indefinitely.]
3. Mr Murray requested risk analysis on the project so it is necessary to check which chip crusher (HCC or LCC) made financial sense before it is accepted.
a) Show a sensitivity analysis of NPVs (derived in Question 2) to changes in annual processed scrap revenue and cost of capital individually. Assume each of these variables can deviate from its estimated value by plus or minus 20%.
b) Determine how far the annual net operating cash flow could fall short of forecast before the chip crusher would be rejected.
c) After reviewing the data provided, you realised the revenue and cost figures have not been adjusted for inflation which is another source of uncertainty. Some people were talking about a zero long-term inflation rate, but you wondered what would happen if inflation is 2.5% per annum.
4. Consider all information given in the case study and the results derived in Questions 1 to 3. Advise the executive committee and Mr Murray on which chip crusher (LCC or HCC) they should invest.
5. Discuss the reasons for your recommendation and any reservations you may have in given this advice.
MARKING GUDE
QUESTION MARKS ALLOCATED
1. Prepare the cash flow table (which incorporates
taxes and includes initial investment, operating and terminal cash flows) for each chip crusher using the information given in the case. 10 MARKS EACH = 20 MARKS
2. Which chip crusher (HCC or LCC) would you recommend Nova to purchase based on the
payback period (PP), internal rate of return (IRR), net present value (NPV) and equivalent annual value (EAV) methods? 5 MARKS EACH = 10 MARKS
3. Mr Murray requested risk analysis on the
project so it is necessary to check which chip crusher (HCC or LCC) made financial sense before it is accepted. 20 MARKS
4. Consider all information given in the case study and the results derived in Questions 1 to 3.
Advise the executive committee and Mr Murray on which chip crusher (LCC or HCC) they should invest. 10 MARKS
5. Discussions – clear and relevant suggestions to management. 10 MARKS
Presentation, and ELP quality:
– Quality of document presentation
– Language, grammar and spelling 10 MARKS
MARKED OUT OF 80 SCALED TO 40% OF FINAL GRADE
NOTE THAT IN EACH CATEGORY ABOVE, MARKS WILL BE ALLOCATED ON THE BASIS OF ACCURACY OF COMPONENTS WITHIN THE CATEGORY.
E.G. MARKS WILL BE ALLOCATED FOR EACH ITEM IN YOUR CASH FLOW TABLE. THEREFORE IT IS IMPORTANT THAT YOU GIVE A COMPLETE BREAKDOWN OF EACH ITEM WITHIN THE CASH FLOW TABLE.