The investment envisaged by the production manager of Hillside to carry on with the business expansion entails the installation of a newly developed, fully automated production technology in the new plant. The details associated with this investment are as follows:
Forcasted Future Free Cash Flows (Years)
Initial Investment 1 2 3 4 5
$270 000 $47 000 $61 000 $95 000 $97 000 $150 000
1. Based on the previous behaviour of the company’s stock, the beta of Hillside’s shares is Moreover, the current economic scenario is such that the risk-free interest rate is 1% per year, with financial analysts expecting a rate of return of 6% on the market portfolio (i.e., the relevant index representing the stock market). Hillside has also previously issue corporate debt that will mature in 15 years ($1,000 face value, 4% annual coupon rate) currently priced at $896. Finally, the company’s liabilities amount to 60% of its balance sheet and assume the tax-shield in Australia as 30%.
Key questions to be addressed
1. Based on the background provided in the case study, you are to write a report addressing the following key questions:
In terms of working capital requirements, what are the implications of increasing the payment period (or average collection period) from 15 to 30 days? Please refer to the operating and cash conversion cycles in your answer.
2. Based on the forecasted sales, is it possible for Hillside to achieve the corresponding cash and accounting break-even points? Based on your calculations for each – and from a pure cost management perspective – is the marketing department’s proposal acceptable? Explain.
3. Use the net present value (NPV) criteria to assess whether the expansion plan is warranted (Hint: use Hillside’s weighted average cost of capital as its discount rate and the CAPM to calculate the cost of equity). Explain to the BoD the benefits of the NPV vis-a-vis other capital budgeting methodologies.
4. Based on the cost of equity and the cost of debt, which of the two sources (bonds or shares) should the company use to raise the funds for the expansion plan? Explain the reasons behind your decision.
5. Based on the answers to the previous questions, determine whether to endorse the recommended plan to the Board.
