Conducting sensitivity analysis

Reference no: EM131481611 , Length: word count:1500

Format: This assignment is a problem solving exercise, using Excel spread sheets, with discussion of findings. The word limit is 1,500 words (1,000 words for Part 1 and 500 words for Part 2).

Part 1
Riverlea Limited is a public listed company that specialises in the production of confectionery. The production relies heavily on the use of machine. The number of shares outstanding of the company is 100,000.

Riverlea is currently in negotiation with a large supermarket chain, Wowcoles, to supply its confectionery in a private label for Wowcoles. Under the terms, Riverlea is expected to supply confectionery to Wowcoles every year for the next ten years.

If Riverlea proceeds with the supply of confectionery, the company needs to purchase machinery to cope with the increase in production. New machinery is expected to cost $1,300,000, with an additional $200,000 installation and shipping costs. The machinery is expected to have a working life of 10 years. The company's accounting policy is to depreciate using the straight-line approach.1 It is expected that the new machine can be sold for $200,000 at the end of its useful life.

If Riverlea is to proceed with the supply of confectionery to Wowcoles, it is expected that the yearly operating revenues would increase by $720,000 and remain constant at that level, while operating costs associated with increased production would be constantly $200,000 per annum. However, as the private label confectionery's selling price is cheaper than Riverlea's brand, it is expected that Riverlea's existing operating revenues would fall by $150,000 per annum and existing operating costs would decrease by $50,000 per annum if Riverlea proceeds with the supply of confectionery. Moreover, there would be an initial increase in net working capital of $50,000. The net working capital can be recovered at the end of year ten.

The company requires you to calculate an appropriate discount rate using the Capital Asset Pricing Model (CAPM). Riverlea is an all-equity firm with an equity beta of 1.20. Riverlea has decided to use ASX200 index to represent the market, and the 90-day Australian Treasury Bill as a proxy for risk free asset. Based on the current state of economy, Riverlea has determined that the expected return on ASX200 is 15% per year, and the 90-day Australian Treasury Bill rate is 4.50% per year. The company tax rate is 30%.

Furthermore, the CEO suggests conducting sensitivity analysis as follows because of uncertainty in relation to some of the expected cash flows:

1) Allow for a 30% probability that incremental revenues associated with the supply of private label confectionery would be 20% lower than expected starting from year six;

2) Allow for a 20% probability that incremental revenues associated with the supply of private label confectionery would be 20% higher than expected starting from year six.

Required

You are to prepare a spread sheet, to present to the CEO, showing the various cash flows based on the different scenarios; assuming that the company decides to proceed with the supply of private label confectionery to Wowcoles.

Use Excel to prepare a full analysis, evaluating whether or not the company should proceed with the supply of private label confectionery to Wowcoles, taking into consideration the various scenarios.

Show all formulae, adjacent to the corresponding calculated amounts in the spread sheet.

Part 2

Semi-strong form efficiency tests are concerned with whether security prices reflect all publicly available information. The event study methodology can be used to investigate the effects of many events such as a corporate announcement. By studying the stock price reaction before, during and after an announcement, an examination of whether the market is semi-strong form efficient can be conducted.
After performing the full analysis in Part 1, assume that the company decides to proceed with the supply of private label confectionery to Wowcoles. As such, the company announces details related to the increase in profits that it would achieve from the supply of private label confectionery. The table below shows the closing stock price of Riverlea 5 days before and after the announcement. Day 0 is the day of the announcement and assume that there is no other price-sensitive announcement within the event window.

Day	Stock Price ($)
-5	2.20
-4	2.23
-3	2.16
-2	2.20
-1	2.70
0	4.85
1	4.77
2	4.82
3	4.75
4	4.78
5	4.65

Required

Plot the stock price of Riverlea 5 days before and after the announcement. Discuss the stock price behaviour of Riverlea before, during and after the announcement and justify whether the stock price reaction is consistent with semi-strong form market efficiency. Your response should also include recommendations of a trading strategy to exploit mispricing opportunities, if any, and expectations of what would happen to the share price subsequent to the analysed event window.

Reference no: EM131481611

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Reviews

len1481611

5/2/2017 7:01:40 AM

General Structure and presentation No evidence of structure or thought of presentation Poor attention to structure and presentation Limited attention to structure and presentation Satisfactory attention to structure and presentation Appropriate attention to structure and presentation Superior attention to structure and presentation 5% Writing style and grammar No evidence of checking for style and grammar Poor attention to style and grammar Limited use of style and grammar Satisfactory use of expression, but contain spelling errors Appropriate use of expression with minimal spelling errors No easily discernible errors in expression 5%

len1481611

5/2/2017 7:01:34 AM

Part 2 Plot of stock price behaviour on a graph None provided Poor plot - e.g., no labels and descriptions Adequate plot - e.g., Unclear labels and descriptions Satisfactory plot - e.g., reasonable labels and descriptions Appropriate plot - e.g., appropriate labels and descriptions Superior plot - e.g., clear labels and descriptions 5% Discussion on stock price behaviour before, during and after announcement No evidence of discussion Poor discussion on stock price behaviour Limited discussion on stock price behaviour Satisfactory discussion on stock price behaviour Appropriate discussion on stock price behaviour Superior discussion on stock price behaviour 20% Trading strategy None provided Poor recommendation Limited recommendation Satisfactory recommendation Appropriate recommendation Superior recommendation 5%

len1481611

5/2/2017 7:01:27 AM

Traits 0 1 2 3 4 5 Mark granted Weight Sub-total Not attempted Inadequate Just adequate Acceptable Very good Exemplary Part 1 Knowledge and understanding of spreadsheet application No evidence of use of spreadsheet Poor use of spreadsheet - e.g., no formulas Limited use of spreadsheet - e.g., limited use of formulas Satisfactory use of spreadsheet - e.g., reasonable use of formulas Appropriate use of spreadsheet - e.g., formulas used, but minor errors Competent use of spreadsheet - e.g., correct formulas 40% Conclusions and recommendations None provided Poor connection between analysis and conclusions Limited connection between analysis and conclusions Satisfactory connection between analysis and conclusions Appropriate connection between analysis and conclusions Superior connection between analysis and conclusions 20%

len1481611

5/2/2017 7:00:59 AM

The objective of this assignment is to encourage students to use Excel spread sheets to aid in solving a capital budgeting problem, and analyse how the market impounds new information into stock prices. Australian student, 1500 words Format: This assignment is a problem solving exercise, using Excel spread sheets, with discussion of findings. The word limit is 1,500 words (1,000 words for Part 1 and 500 words for Part 2).

len1481611

5/2/2017 7:00:20 AM

Marking Marks will be awarded for: • Setting up of spread sheet for the Riverlea i. Ease of reading spread sheet ii. Use of formulae in spread sheet iii. Correct application of theoretical model • Writing of report iv. Statement of assumptions v. Correct recommendation based on analyses vi. Coherence of arguments vii. Presentation, grammatical structure, referencing, etc. Refer to the corresponding marking rubric on the Blackboard site for this unit.

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