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## Individual Assignment

MBA Programme

Issue Date: July 30, 2012

Table of Contents

Table of Contents

2

I.

Introduction and Problem Identification

3

II.

Analysis

4

## A.

Calculation of Earnings from Investment in Securities

4

B.

Calculation of Project Cash-Flows

5

C.

Funding the Proposed Project

9

D.

Calculation of Project Cash-Flows

9

III.

Conclusion and Recommendations

10

IV.

Calculations

11

I. Introduction and Problem Identification

The Unit Building Company (UBC) is an established private company specializing in the production of precast concrete panels. For the last three years, UBC’s financial performance has been wanting, as well as their investments in external securities. However, in 2011, the company through the leadership of its new CEO experienced a resurgence in terms of profitability and business growth.

UBC has been working with Caranella Continental Properties (CCP), a company specializing in the development of holiday homes in the Mediterranean, on the development of cheap chalets for sale at a significant discount to current market offerings. To do so, CCP uses pre-fabricated lightweight panels, a product that UBC produces. With this collaboration, UBC is expected to become the sole supplier of these panels to CCP, utilize old and new equipment and other capital assets, and make a decision on the use of the company’s limited cash resource.

UBC’s potentially lucrative new business opportunity must be supported by appropriate financial and managerial analyses. To aid UBC, analysis must be conducted on the UBC’s capability to raise either debt or equity financing, determine the cost of both sources, calculate the Weighted Average Cost of Capital (WACC) employed, and determine the long-term impact on shareholder dividends and total corporate value of the potential undertaking.

II. Analysis

## A. Calculation of Earnings from Investment in Securities

UBC is currently using its internally generated cash reserves to invest in securities. The company has invested a total of 259, 000 by 2011. In the same year, this investment gave UBC a cash yield of 13% or 32, 382. From 2009 to 2012, the company has plowed in an average of 62% of its mandatory cash reserve into external securities, receiving an average return of 10% per annum. Shown below are the historical investments and returns and a projection of the 2012 investment, should UBC continue with this option.

Table 1 UBC’s Investment in External Securities

2012 (Projection)

## Cash Reserves

Cash Re-Invested

% of Reserves Re-Invested

## Investments

Yield

% Return

## 3-Year Average Return

This investment option is what UBC will be giving up, if it decides to pursue new business with CCP. The investment amount and returns are calculated as follows:

## Cash reserves – taken from the Income Statement (provided)

Cash re-invested – UBC has been investing in external securities previously and adds on to their investment annually. The additional investment is taken from its cash reserves. The amount re-invested is the difference between this year’s cash reserve and next year’s total investment. From 2010 to 2011, the average percentage of cash reserves that UBC reinvested is 62%.

For the year 2012, the amount of cash re-invested is 194 thousand, calculated as the product of 2011’s cash reserve X 62% average re-investment factor.

The yield on UBC’s investment is growing annually. In 2009, the total return on its investment was only 7% but this jumped to 13% in 2011. The projected return on the 2012 is 45, 122 or about 10% of the cash re-invested.

## The projected 2012 investment on external securities is 453 thousand.

B. Calculation of Project Cash-Flows

UBC’s cash flows are calculated during the relevant 10 year period (excluding the year 0 period or the initial investment date).

Free cash flow is what is left over from total revenues after removing operating costs taxes, net investments and working capital requirements. Free-cash is calculated, as shown in the table below.

Sales revenues are provided in the case facts. The expected sales revenue will peak on year five and will be maintained up to the 10th year. The incremental growth from 2012 to 2016 was calculated by taking the difference between the projected sales revenue in 2016 and 2012 and dividing the result by four years.

## Revenue from annual rental of a 100-square meter excess space is excluded from this calculation.

Operating cash requirement is derived by taking 60% off the total sales revenue for the pre-fabricated boards. Gross profit is calculated by subtracting the Annual Operating Costs from the Total Revenue.

The income statement for years 2009 to 2012 showed income tax payments of 36% (2009 and 2011) and 29% (2012). The tax rate is calculated by taking the average annual income tax paid and dividing it by the average Before-Tax profit. The result is an average tax rate of 32%. However, because of the type of investment that will be made, a “ special” tax rate of 25% is applicable for equipment and plant machinies.

## This special tax rate is used to calculate the income tax payments, as shown in the free-cash flow calculations.

Net investments are calculated based on the cash required for making the capital investments, less annual depreciation.

Working capital requirements are projected. This is based on the average current assets less the average current liabilities of UBC from 2009 to 2011.

Table 2 Free Cash Flow Calculation

## Sales Revenues

Rent

100 square meters

## Total Revenues

Operating Cost

Percentage Operating Cost

Cost of Good Sold

Gross Income

Tax Payments

Tax Rate Used

Tax Payments

Net After-tax Income

Net Investment

30, 000

## Land

New Equipment 1

New Equipment 2

New Equipment 3

Annual Depreciation

Net Investment

Working Capital

Free Cash Flow

The cash flow presented above assumes an all-equity scenario (i. e. all investments are financed by UBC). In this case, the profitability of the project is computed to be:

Table 3 UBC’s New Business Profitability Calculations

## Profitability Measure

Hurdle Rate

Returns

Net Present Value

Internal Rate of Return

The Net Present Value (NPV) of the proposed business is calculated as discounted cumulative cash flow, and is given by the formula:

NPV = -I0 + CF1 / (1+i)1 + CF2 / (1+i)2 + I + CFn / (1+i)n

## Where:

I: initial investment

CF: cash flow

i: interest rate for the project, set at 10% to approximate the advantage of the proposed new business and that of UBC’s current investment in external securities.

The NPV results show a positive 3. 65 million return. This means that the project will yield positive cash flows to the company, over the 10-year projected operating life. However, the calculation for NPV uses a 10% hurdle rate, which is the average yield on UBC’s investments in securities.

The Internal Rate of Return (IRR) or the hurdle rate that would yield an NPV equal to zero (0) for UBC is calculated to be 35. 48%.

C. Funding the Proposed Project

The proposed business is very promising. However, UBC must still determine the optimal way of funding the project. It can fund this project by using its cash reserves or by acquiring debt financing. The required investments for this project are:

Table 4 UBC’s Required Investments

## Required Investments

Total Investments

1. Cash Reserves

UBC has a policy on cash reserves. From 2009 to 2011, the company directed an average of 56% of its after-tax profit to reserves. As of 2011, the company has 1. 3 million in cash reserves that could be used for re-investments, as shown in the table below.

Additionally, UBC has cash reserves in the form of investments. As of 2011, UBC has made investments made in external securities amounting to 259, 052. This could be liquidated to add to the cash funds that UBC can invest in the project. The total cash that UBC could invest in this project is 1. 3 million without liquidating investments in securities or 1. 5 million inclusive of the value of external securities.

Table 5 UBC’s Sources of Funds

## Cash transferred to reserves

Cash reserves

Investments in securities

Total Cash Available for Re-investment

Requirement to be Financed Externally

Total Cash Required for New Project

3, 006, 000

2. Debt Financing

With UBC’s recent performance and the prospect of the new business, UBC’s management may seek financing from institutional funding organizations such as commercial banks. The terms that would be reasonable for URC to seek for debt financing would be as follows:

## Amount:

Minimum of 70% of required investment or 2. 1 million

Term:

5 years

Interest rate:

British Pound Sterling 12-month LIBOR + 2%, fixed over the term of the loan

## No financial covenants

The Debt-Equity ratio of 70-30 provides UBC with the full fund sourcing without depleting UBC’s cash coffers. In addition, it also enables UBC to continue engaging in external securities, as a way of managing its “ portfolio” of investments. The fund sources for the project are thus:

Table 5 Proposed Debt-Equity Ratio for New Project

## UBC Equity

Commercial Loan (Debt)

3. Weighted Average Cost of Capital

The Weighted Average Cost of Capital is calculated to determine the expected returns of the project and the additional value created for UBC’s shareholders. To determine the WACC, the formula below is used:

## Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm’s equity

D = market value of the firm’s debt

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

The calculated WACC is shown in the table below. The figures used in the calculation of WACC are shown in the table as well.

Table 5 WACC Calculation

## Where:

+++*++++

Debt

70. 00%

Assumed

Equity

30. 00%

Assumed

Tax rate

25. 00%

From case files

Market risk premium

8. 0%

http://www. iese. edu/research/pdfs/DI-0920-E. pdf

Average beta unlevered

Risk free rate

8. 00%

http://www. careratings. com/Portals/0/Reports%20and%20Updates/Sintex%20Industries%20Ltd. pdf

Cost of debt

3. 49%

British Sterling Pound 12-Month Libor + 2%, from http://www. global-rates. com/interest-rates/libor/british-pound-sterling/british-pound-sterling. aspx

Cost of equity

31. 33%

Calculation

WACC

11. 23%

Calculation

D. Calculation of Project Cash-Flows using WACC

The project cash flows are then re-calculated using WACC as the hurdle rate and with the inclusion of debt financing (interest payments) as part of the cash flows. The table below summarizes these changes.

Table 8 Revised Project Cash Flows with Interest Payments

Total Revenues

Operating Cost

Cost of Good Sold

Interest Payments

Interest payments

Tax Payments

Tax Payments

Net Investment

Net Investment

Working Capital

Free Cash Flow

The free cash flows represent the amount of cash that is available for shareholders, either to be distributed as dividends or to be retained for re-investment in other projects. The profitability of the revised cash flow projections is lower than the all-equity scenario because of the effect of paying interest on the loans, but the lower cost of debt funding has preserved the commercial attractiveness of the project. With less exposure for UBC in terms of actual cash outlay, the IRR’s have remained within striking distance of each other and the NPVs differ only by 532 thousand. Dividends will be higher for the shareholders, except for one year (2012) which would be due to the utilization of the cash for investments. The dividend payout rate used is 44%, the three-year average dividend payout from 2009 to 2011.

Table 9 Comparative Returns of Using Equity and Using a Combination of Debt and Equity

With Debt Financing

At All-Equity

Profitability Measure

Hurdle Rate

Returns

Hurdle Rate

Returns

Net Present Value

Internal Rate of Return

III. Conclusion and Recommendations

Assuming that the market risks are all acceptable and the technology for producing the pre-fabricated building materials are plausible to manufacture, then the proposed new business should be taken up by UBC immediately.

The calculation of the expected returns, using very costly equity or in combination with debt financing, show that the project will yield positive results for UBC. In addition, financing with debt enables the company to retain its external investment policy, which are providing returns are lower yields but are intrinsically important for the management of the company’s investment portfolio, continue its dividend payout policy and its cash reserve policy.

If space that could be leased out to third parties is available, it should be included in the calculations but that right now may just be icing on UBC’s cake.

IV. Calculations

All the calculation results contained in this paper are presented in the attached Microsoft Excel worksheet. The figures, statistics and facts used in the calculations were derived from the case files or sourced through internet publications.