Corporate - Finance - Assignment PDF

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Corporate Finance Assignment: 1. Calculate BAX’s company after-tax WACC, rounded to four decimal places. WACC = rd (D/V) (1-tax) + re (E/V) CAPM  re = rf + B (rm – rf) Re = 0.0282 + 1.44(0.065) Re = 0.1218 = 12.18% WACC = 0.074 (69,000,000/254,574,000) (1-0.3) + 0.1218 (185,574,000/254,574,000) WACC = 0.102827 = 0.1028 = 10.28%

rf = 2.82% (given) rm = 9.32% (rm – rf) = 6.5% (given) D = $69 mill (given) E = 94.2 * $1.97 = $185,574,000 V = $69,000,000 + $185,574,000 = $254,574,000 re = 12.18% rd = 7.4% (given) Beta = 1.44 (given)

2. Calculate the Water Products division WACC, rounded to four decimal places. WACC = rd (D/V) (1-tax) + re (E/V) CAPM  re = rf + B(rm – rf) Re = 0.028 + 1.8 (0.065) Re = 0.1452 = 14.52% WACC = 0.073 ($12mil/$32mil) (1-0.3) + 0.1452 ($20mil/$32mil) WACC = 0.1099125 = 0.1099 = 10.99%

rf = 2.82% (given) rm = 9.32% (rm – rf) = 6.5% (given) D = 0.6 * $20mil = $12mil E = $20mil (given) V = $12mil + $20mil = $32mil re = 14.52% rd = 7.3% (given) Beta = 1.80 (given)

3. What was the reason for BAX to set the FAR at the market median? BAX is to set the FAR at the market median to create equality with comparative firms. Aligning the fixed annual remuneration with comparative firms avoids any agency problems that may arise within a firm. One major issue is in relation to compensation becoming too generous. There is a widespread concern that excessive pay will result in a mediocre performance which consequently results in poor governance, as there is no immediate response to changes that may or have occurred in the market/firm. 4. What was the reason to use the financial measure of Return on Net Assets, in addition to profit after tax including significant items for STIP? The reasons to use the financial measure of Return on Net Assets as it highlights how well a company can use an asset base to maximise its profits. They include significant items such as STIP as it is based on financial performance in line with agreed annual business plans and targets. 5. Would Singleton be able to receive any LTIP reward, based on EPS growth criterion? Explain.

6. What was the underlying reason for BAX to benchmark its TSR against an external market performance? The underlying reason for BAX to use TSR to benchmark itself against external market performance as it shows an increase or decrease in the value of shares market prices and dividends received over a period of time. TSR is a principle of corporate performance and highlights transparency, simplicity and strong alignment with shareholders over time.

7. Complete table 1 fully, in accordance with the given assumptions, to show how the free cash flow in years 1-5 is derived.

Revenue Variable Cost Fixed Cost Depreciation Operating Income Tax (30%) Net Income Depreciation Operating Cash Flow Inv. In Fixed Assets Inv. In Working Cap. Free Cash Flow

Table 1 Free Cash Flow for the Water Products Division ($'000) t=1 t=2 t=3 t=4 18000 19800 20988 21827.52 12600 13860 14691.6 15279.264 3000 3090 3182.7 3278.181 600 600 600 600 1800 2250 2513.7 2670.075 540 675 754.11 801.0225 1260 1575 1759.59 1869.0525 600 600 600 600 1860 2175 2359.59 2469.0525 900 900 900 900 200 180 118.8 83.952 760 1095 1340.79 1485.1005

8. Calculate the terminal value as of year 4 using the constant growth discounted cash flow formula

PV[h] = (FCF [h+1])/ (WACC-g) PV[h] = 1572.241515/ (0.1099-0.03) PV[h] = $19,677.616

WACC = 10.99% H = 4 (given) G= 3% (given)

t=5 22482.3456 15737.64192 3376.52643 600 2768.17725 830.453175 1937.724075 600 2537.724075 900 65.48256 1572.241515

9. Show individually the discounted value, as of year 0, of the free cash flow in years 1-4 plus that of the terminal value. What would be the present value, as of year 0, of the water products division? PV (company) = PV (cash flow years 1-4) + PV (Horizon Value) PV(company) = 760/(1.1099)^1 + 1095/(1.1099)^2 + 1340.79/(1.1099)^3 + 1485.1005/(1.1099)^4 + 19,677.616/(1.1099)^4 PV [0] of Water Products Division = $16,499.833376

Cash Flow (FCF) t=1 t=2 t=3 t=4 t=5 onwards (terminal) Total($'000)

Discounted Value

760 1095 1340.79 1485.1005 19674.53796

684.74637 888.8867 980.6391 978.6343 12,966.93 16499.83376

10. Calculate the economic depreciation in year 1 based on the free cash flows in Table 1. Economic depreciation = PV (0) – PV (1) Economic depreciation = 16125.41553 – 16499.83376 = 374.4182282

PV0 ($'000) PV1 ($'000): t=1 t=2 t=3 t=4 Total ($'000) Economic Depreciation ($'000) =

PV (0) = 16125.41553 PV (1) = 16499.83376

16499.83376 Cash Flow Discounted Value 1095 986.5642562 1340.79 1088.386828 1485.1005 1086.149525 19674.53796 12964.31492 16125.41553 374.4182282

11. As a scenario analysis, calculate the value of the Water Products division as of year 0 if the growth rate of the revenue and fixed cost in years 2-5 are both 3% and the investment in working capital in years 2-5 is equal to 20% of the change in revenue from the previous year. Other assumptions and cash flows in year 1 remain unchanged.

Revenue Variable Cost Fixed Cost Depreciation Operating Income Tax (30%) Net Income Depreciation Operating Cash Flow Inv. In Fixed Assets Inv. In Working Cap. Free Cash Flow

Table 1 Free Cash Flow for the Water Products Division ($'000) t=1 t=2 t=3 t=4 18000 18540 19096.2 19669.086 12600 12978 13367.34 13768.3602 3000 3090 3182.7 3278.181 600 600 600 600 1800 1872 1946.16 2022.5448 540 561.6 583.848 606.76344 1260 1310.4 1362.312 1415.78136 600 600 600 600 1860 1910.4 1962.312 2015.78136 900 900 900 900 200 108 111.24 114.5772 760 902.4 951.072 1001.20416

PV[h] = (FCF [h+1])/ (WACC-g) PV[h] = 1052.840285/ (0.1099-0.03) PV[h] = $13176.97478 PV (company) = PV (cash flow years 1-4) + PV (Horizon Value) PV(company) = 760/(1.1099)^1 + 902.4/(1.1099)^2 + 951.072/(1.1099)^3 + 1001.20416/(1.1099)^4 + 13176.97478/(1.1099)^4 PV [0] of Water Products Division =$10595.55063

t=5 20259.15858 14181.41101 3376.52643 600 2101.221144 630.3663432 1470.854801 600 2070.854801 900 118.014516 1052.840285

12. Using the appropriate project cost of capital to discount “upgrade “ cash flow projections in table 2, calculate the NPVt=1 of the “Upgrade” project. The project is considered to be low risk, therefore, the appropriate project cost of capital = divisional WACC – 1.5% = 0.109913 – 0.015 = 0.094913 Discounted value = cash flow/ (1+ cost of capital) Cash Flow t=1 t=2 t=3 t=4 t=5 Total ($'000)

Discounted Value -2200 360 430 470 3800

-2200 328.7933967 358.6820372 358.0631403 2644.027337 1489.565911

13. Calculate the value of the Water Products division, as of year 0, with the Upgrade project considered. Value of Water Products division (0) = Value of Water Products division at year 0 + Value of upgrade project at year 0 Value of Water Products division at year 0 = 16499.83376 Value of upgrade project at year 0 = 1360.422877 Therefore = 16499.83376 + 1360.422877 = 17860.27664

Cash flow t=1 t=2 t=3 t=4 t=5 Total ($'000)

760 902.4 951.072 1001.20416 13176.97478

Discounted Value 684.7386618 732.5235672 695.5801317 659.7321907 7822.976077 10595.55063

14. If the Water Products division were to be sold in a year’s time, calculate the minimum selling price. Assume BAX had already received the free cash flow of $760,000 in year 1. Minimum selling price = PV of Water Products Division at beginning of year 2 + PV of expansion project at beginning of year 2 Minimum selling price = 16125.41553 + 3689.565911 = 19814.98144

PV of Water Products Division at beginning of year 2 Cash Flow t=2 t=3 t=4 t=5 Total($'000)

1095 1340.79 1485.1005 19674.53796

PV of expansion project at beginning of year 2 Cash Flow t=2 360 t=3 430 t=4 470 t=5 3800 Total ($'000)

Discounted Value 986.5642562 1088.386828 1086.149525 12964.31492 16125.41553

Discounted Value 328.7933967 358.6820372 358.0631403 2644.027337 3689.565911

15. Was there any need for BAX to reduce its gearing? Explain.

Let us return to the question of what mixture of equity and debt will result in the lowest WACC. The instinctive and obvious response is to gear up by replacing some of the more expensive equity with the cheaper debt to reduce the average, the WACC. However, issuing more debt (ie increasing gearing), means that more interest is paid out of profits before shareholders can get paid their dividends. The increased interest payment increases the volatility of dividend payments to shareholders, because if the company has a poor year, the increased interest payments must still be paid, which may have an effect

the company’s ability to pay dividends. This increase in the volatility of dividend payment to shareholders is also called an increase in the financial risk to shareholders. If the financial risk to shareholders increases, they will require a greater return to compensate them for this increased risk, thus the cost of equity will increase and this will lead to an increase in the WACC. 1. the ratio of a company's loan capital (debt) to the value of its ordinary shares (equity).

16. If BAX were to use (part of or all of) the sale proceeds of the Water Products division for a payout to shareholders, in which specific form of payout should BAX choose to use? Explain the details. A sale of an asset or extra cash flow through a company can be used for a ‘one-off special dividend’ which can be a dividend payout to shareholders using the sales proceeds of the Water Products Division. This dividend is not expected to be repeated.

17. Provide a valid reason for the DRP to remain suspended. DRP’s may result in more cash being retained than companies can invest

18. If BAX decided to retain the Water Products division and the firm’s financial position at the commencement of the Upgrade project next year remained the same as at 30/06/2015, name the specific source of finance to fund the Upgrade project....