Recent Question/Assignment

FIN80005 Corporate Financial Management - Individual
Assignment 1
Semester 2, 2022
The objective of this assignment is to encourage students to use Excel
spreadsheets to aid in solving a capital budgeting problem, and to analyze how the
market impounds new information into stock prices. Topics 4 - 7 are particularly
relevant for this assignment.
Weight: 20% of the total assessment
Due date: Check on Canvas. You must submit your report, in word or PDF
format, electronically using the assignment submission link on Canvas.
Late submissions: Late assignments cannot be accepted unless a time extension
has been requested from, and approved by, the Unit Convenor. Such requests
must be made in writing via email before the due date. You will be penalized 10%
of the assessment’s worth for each calendar day the task is late, up to a maximum
of 5 days. After 5 calendar days, a zero result will be recorded.
Format: This assignment must be written in a report format. Excel tables must be
copied across to the body and/or appendix of the report and presented neatly.
This report would be approximately 1,500 words excluding the executive summary,
table of contents, list of figures, tables, references, and appendix. Report writing
resources are provided on Canvas.
Hypothetical company background
You are a financial analyst working in the finance department of Safe-Drive Limited.
Safe-Drive is a publicly listed company that specializes in the production of auto parts.
The mass production of Safe-Drive relies heavily on the use of machinery. The company
has 1,756,000 shares outstanding trading on the stock exchange, and it is currently trading
at $3.20 per share.
Part 1
Safe-Drive Limited is an auto-parts manufacturer with a large customer base due to its
quality products. Currently, Safe-Drive is in a negotiation with a large auto-parts chain,
Extracheap Limited, to supply its brake parts in a private label for Extracheap. Under the
terms, Safe-Drive is expected to supply multiple brake parts to Extracheap every year for
the next eight years. However, some managers and employees of Safe-Drive are not
happy with this negotiation as they are anticipating that the overall production quality of
the company will be waned by producing parts for Extracheap and it will damage the
reputation of Safe-Drive.
If Safe-Drive proceeds with the supply of brake parts, the company needs to purchase
machinery to cope with the increase in production. New machinery is expected to cost
$2,800,000, with an additional $500,000 in transportation and installation 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 of 9% per year. It is expected that
the new machinery can be sold for $460,000 at the end of the project life.
If Safe-Drive is to proceed with the supply of brake parts to Extracheap, it is expected
that the yearly operating revenues would increase by $3,600,000 in year one. From year
two onwards, it is expected that the increase in yearly operating revenues would grow at a
rate of 5% per annum. Total variable costs associated with the increased production
would be 60% of the increase in yearly operating revenues. The fixed costs associated
with the increased production are expected to be $480,000 per year. Furthermore, there
would be an initial increase in net working capital of $360,000. From year one to year
seven, net working capital is expected to increase by $15,000 per year. All the net working
capitals can be recovered at the end of the project’s life.
The sales manager predicts that the existing brake parts sales revenue of Safe-Drive will
decrease by $400,000 per annum if Safe-Drive proceeds with the supply of brake parts to
Extracheap as some marginal or one-off customers will switch from Safe-Drive quality
brand to economy brand of Extracheap. Consequentially, decreasing sales will decrease
production and the existing operating costs would decrease by $125,000 per annum.
Given that this project’s risk level is not significantly different, you believe that it is
appropriate to use the existing WACC of 14.00%. The company’s capital structure has
remained fairly stable, with a debt-to-equity ratio of 0.55. The company has no plan to
adjust its capital structure in the future. The company tax rate is 30%.
Furthermore, the CEO is concerned about the uncertainties in relation to some of the
cash flows and suggested conducting a sensitivity analysis as follows:
1. Allow for a 25% probability that incremental revenues associated with the supply of
private label brake parts would be 20% lower than expected starting from year five.
2. Allow for a 25% probability that incremental revenues associated with the supply of
private label brake parts would be 20% higher than expected starting from year five.
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, Safe-Drive decides to proceed with the supply
of private label brake parts to Extracheap (regardless of the NPV and other investment
analyses). As such, the company announces details related to the expected increase in
profits and net cash flows that it would achieve from the supply of private label brake
parts. The table below shows the daily returns of Safe-Drive (stock), the market, and the
risk-free asset 5 days before and after the announcement. Day 0 is the day of the
announcement and there is no other price-sensitive announcement within the event
window. The company has an equity beta of 1.30.
Table 1 Daily returns for Safe-Drive, market, and risk-free asset during the event window
Day Stock Return Market Return Risk-free
-5 0.13% 0.02% 0.0057%
-4 0.19% -0.08% 0.0057%
-3 0.32% 0.17% 0.0057%
-2 0.28% 0.42% 0.0057%
-1 -0.07% 0.04% 0.0057%
0 -2.85% 0.12% 0.0057%
1 0.12% 0.55% 0.0057%
2 0.21% 0.71% 0.0057%
3 1.05% 0.09% 0.0057%
4 2.32% 0.30% 0.0057%
5 1.65% 0.24% 0.0057%
You are to prepare a report, to present to the CEO, based on the Excel analysis you
conduct for Part 1 and Part 2.
Part 1
Show the various cash flows based on the different scenarios; assuming that the SafeDrive decides to proceed with the supply of private label auto-parts to Extracheap; taking
into consideration of the various scenarios. You should also clearly state any assumptions
(if any) made in your analysis. Based on your analysis, is this project a good investment
project for Safe-Drive?
Part 2
Using Capital Asset Pricing Model (CAPM), calculate the daily abnormal return of SafeDrive during the event window and plot the cumulative daily abnormal returns on a
diagram. Daily abnormal return is computed as:
Abnormal Return = Actual Return - Expected Return (1)
Discuss the abnormal return pattern of Safe-Drive 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: (1) whether the abnormal return pattern is consistent
with the analysis conducted in Part 1; and (2) expectations of what would happen to the
share price subsequent to the analyzed event window.