Reference no: EM133146083

Business Presentation

Task: This assignment will require your team to advice a company on undertaking a new project, and its dividend policy. The assignment will cover the topics capital budgeting, risk and return, cost of capital, and payout policy.

Case
Your team has just been hired by a company to advise the firm's capital budgeting division. The company has raised a sum of money, which will be invested in a new project. From your team of financial specialists, they are seeking advice on the financial feasibility of one of the proposed projects, and its potential effects on the wealth of the shareholders of the company.

Over the last two years, the company has already spent $100,000 on R&D for the newly proposed project. If the company would decide to actually go ahead with the project, the initial investment in the required equipment is expected to be $1,080,000. The new project is expected to run for 10 years, and after that point the project will be retired. The expectation is that at the end of the project, the assets of the project can be sold at a residual value of only 8% of their original value. Half of the total sum which the company has raised for this project has been borrowed at an interest rate equal to the average cost of debt of the company of 4.4%.

In the first year the project is expected to generate a revenue of $648,000, and in the following years the revenues of this new project are expected to grow by 8.8% each year. Your team will have to determine the rest of the cash flows associated with this proposed project. The CFO of the company has indicated that it would be reasonable to expect that the operating costs of the new plant will be of similar proportion relative to the revenues as the company's other projects, which is at 65%. The new project would require an additional NWC of $21,600. Depreciation of the new equipment should be done in a straight-line over the full life of the project to a value of 0.

Based on the already existing projects of the company, which will be running for the foreseeable future, the company is currently able to pay a stable yearly dividend of $5.00 per share. The company has 100,000 shares outstanding, and the shareholders require a return of 14.7%. The company is financed for 70% with equity, and 30% with debt (that is including the new loan). The effective tax rate for the company is 18%.

If the company would decide to go ahead with the project, the yearly cash flows of the project can be partially paid out to the shareholders, and partially reinvested in other projects.

The CFO has indicated that the company intends to have a payout ratio of 40%, such that each year 40% of free cash flows of the project will be paid as dividends.

Requested advice

The company is asking your team for financial advice on two issues:

(1) Do you recommend the company to undertake the proposed project or not?

(2) If this project would be accepted (regardless of your advice), what would be the effect on the wealth of the shareholders?

The results of your analyses will have to be presented to the company's executive management team. The presentation should include (at a minimum!) the following information:

(1) An introduction of each of the team members and their financial expertise.

(2) A brief discussion of the newly proposed project. Which product/service is being developed? (You can choose!)

(3) A demonstration of the expected yearly cash flows from the project. Remember, members of the senior management team often do not have a finance background, so you will have to present clear tables which show the calculation of the free cash flows, and clearly explain how the free cash flows were computed. You basically have to explain them to them in your presentation how capital budgeting works.

(4) Advise on whether or not the company should go ahead with the proposed project. The advice of your team should be based on your estimations of the NPV and the IRR of the proposed project. Again, you will need to explain to executive team what exactly the NPV and IRR metrics are, how they are computed and why they are helpful for making investment decisions. The CFO has asked to use the company's overall cost of capital as discount rate.

(5) A demonstration of the effect of the proposed project on the wealth of the shareholders, if the company would decide to go ahead with the project (regardless of your recommendation) and apply the suggested payout ratio. Present a well-designed figure that shows year by year, the change in the wealth of shareholders (= the share price + total dividends received). Also show their yearly capital gains and dividend yields. Hints:
o Calculate for every year of the project the total dividends paid. (= the stable dividend from existing projects + the paid dividends from the project)
o Calculate for every year the 3-year average growth rate in total dividends - that is the average of the dividend growth rate over that year and the growth rate over the previous two years. (This can be done from year 3 onwards)
o Calculate for each year (from year 3 onwards) the share price using the DDM. You can use the average growth rate over the previous 3 years as the expected dividend growth rate in future.

The company has encouraged the team of advisers to include any critical notes with their findings, suggestions for alternative policies, additional explanations, etc.