FINC 2011 Corporate Finance 1

Semester 2, 2012 Major Assignment

This assignment detailed on the next page requires you to demonstrate your understanding of investment evaluation including capital budgeting techniques and required rate of return estimation. It will be marked out of 25 and constitute 25% of your overall grade. The Assignment is due on Wednesday 24 October at 4pm (Week 12) and must be submitted electronically via the blackboard assignment drop box. It is imperative that all assignments incorporate the assignment cover page and are submitted as ONE document. Documents MUST be submitted as a pdf file to ensure formatting is not distorted. If assignments are not submitted in this way a late penalty will be applied until the document is corrected. Questions about the assignment may be posted on the Blackboard Major Assignment Discussion Board and will be answered from time to time by the academic staff The major assignment is an individual assessment task. While discussion and collaboration are expected, plagiarism is a breech of the University of Sydney Code of Conduct and will be dealt with by the Business School. The assignment must be completed in a maximum of 8 single sided (or 4 double sided) pages including all tables, justifications, calculations and references. You MUST use 11 point Arial only. Line spacing must be 1.5 and margins must be at least 1 cm. You will need to pay particular attention to referencing. References to publications in the text should appear as follows: "Smith (2009) finds that..." or "evidence supports this (Smith (2009))." At the end of the report, a complete list of references should be included using the Harvard referencing style. Data sources and web pages also need to be referenced fully. Pay attention to grammar. Clear and logical presentation is a major challenge in report preparation. Preparing a concise report is another major challenge. Every part of the report should somehow add to the end result otherwise it is superfluous and distracting. Late submissions will be penalised at a rate of 10% per day (or part thereof). A penalty 10% per page will be applied to reports that exceed the page limit. Inappropriate referencing and formatting will each attract a penalty of up to 10%. Note: These percentages are applied to the total marks available for this assessment.

Cicero Mines Investment Analysis

Part 1: 5 marks Cicero Mines is a large mining firm considering the purchase of a new drilling machine. The machine will be used to drill for iron ore at an existing mine site in Australia. Cicero Mines is one of the leading producers of iron ore in Australia. In order to narrow their drill machine search Cicero Mines commissioned a market analysis at a cost of $15000 (yet to be paid). The study identified two candidate machines. Machine A costs $200,000 and will require installation costs of $10,000. Machine A can run for six years at which time it will have a salvage value of $10,000. The machine will require initial working capital of $80,000 and will produce annual revenues of $300,000 and cash operating expenses of $152,000. The salesman for Machine A is offering a loan at 10% per annum compounded monthly for the 6 year life of the machine. Machine B can be purchased for $250,000 and requires installation costs of $8,000. The machine will require initial working capital of $70,000 and will generate annual revenues of $320,000 and cash expenses of $95,000. Its expected salvage value at the end of its ten-year life is $5,000. The tax rate for the corporation is 30% and the company policy is to depreciate assets (including installation costs) to zero using the straight line method. Cicero Mines estimates the covariance between the ASX200 and Cicero Mines to be 0.06. The standard deviation of ASX200 returns is 25% and the standard deviation of Cicero Mines is 35%. The expected return on the ASX 200 is 12% and the risk free rate is 7%. The firm is 100% equity financed. Which Machine should Cicero Mines choose and why (show all working). You need to report to the Board of Directors on the viability of this investment, including a clear explanation of the cash flows under analysis. The Board consists of a cross section of smart people but some have little or no finance training so your report needs to fully describe and justify the evaluation techniques and your final decision. Part 2: 3 marks Discussion regarding the combined effects of the carbon tax and the mining tax, has led you to believe that taxes will increase before the project can be implemented. How does your analysis in part 1 change if the tax rate is increased to 38%?

Part 3: 7 marks As the Chief Investment Officer you are concerned that the values applied to estimate the discount rate have not been updated for several years. As Cicero Mines is not a publicly listed company you need to find a proxy company that reflects the profile of your firm. You need to identify a suitable proxy and collect the required data to empirically estimate a proxy beta that can be applied to Cicero Mines taking care to adjust for changes in leverage. You then use the beta to estimate an appropriate discount rate for Cicero Mines. You will also need to collect data to estimate the risk free rate and the expected equity risk premium. You write a report to the board outlining your analysis of the choice of Machine using the proxy discount rate. In your report you must fully discuss and justify the data you acquired, the time period and data interval used and the estimation procedure you applied. Part 4: 5 marks You are having second thoughts about your choice of proxy company and are concerned that a wrong choice may impact on the investment decision. To alleviate your fears (and those of the board) you run a sensitivity analysis to see how changes in the beta estimate affect your investment choice. You include this analysis in your report to the board and discuss the implications of you analysis. Detailed assessment criteria: Provided a clear discussion and presentation of cash flow determination and discount rate estimation. Demonstrated a complete understanding of project evaluation techniques Demonstrated a clear understanding of the use of the CAPM model and justified the use of proxy data Provided a clear justification on the use of historical data Provided a clear analysis of the sensitivity of the NPV to changes in the beta estimate Provided a clear analysis of the sensitivity of the NPV to changes in the tax rate. Provided a coherent argument and appropriate referencing for data and inputs used in the discount rate evaluation. Provided a coherent argument for the range of betas used in the sensitivity analysis Presented your argument in a logical way Used a range of references to justify your report