Please see the attached assignment below.
Your help is much appreciated.
Assignment – 1
Yesterday, you attended a meeting with Maya and Sam. The project details document was circulated at the start of the meeting. Extracts from the minutes of the meeting are provided below: Sam: Thank you both for meeting with me. I have quite a few questions and issues that I would like some help with. Perhaps we can discuss some now, and then you can make a report for me on these issues. We can then meet later to discuss the remaining issues.
Maya: No problem. How can we help?
Sam: First of all, I would like some information on the cash flows required by our current capital structure.
Maya: We can describe the nature of the cash flows required by each source of financing that TetrraInk currently has outstanding. I think that should meet your needs.
Sam: That will be fine. My next issue relates to raising the $1.5 billion in capital that we will need for the new capital project. As you know, we are considering an issue of new common shares to finance this project. In order to discuss this properly with the board, I would like some information on the primary and secondary markets, and why the secondary market is necessary for the primary market to function properly. In addition, can you explain which market TetrraInk will use to issue these new shares, and why?
Maya: We will include a discussion of these markets in our report. It might also be helpful for the board members if we remind them about informational (pricing) efficiency and why it is also important for smooth functioning in these capital markets.
Sam: That is a good idea. The next concern I have is with respect to TetrraInk’s capital structure and its current cost of capital. I need to know the company’s current cost of capital.
Maya: We can provide the details for this calculation of the company’s current weighted average cost of capital using market values and adjusted for flotation costs. We’ll calculate the debt issue based on $100 face value rounded to two decimals then multiple it out. For this calculation we’ll use the dividend discount model to calculate the common shares.
Sam: Then I will need a new weighted average cost of capital calculated based on the assumption that we will issue new shares to raise all of the new funds required for the capital project. As you know, we are considering whether the company’s current capital structure has too much debt, and we might want to rebalance this with the new equity issue.
Maya: In anticipation of this request, I have already had some preliminary discussions with our investment banker. She has provided me with information on what will likely occur if we proceed in this manner (see the Appendix). Given that they’ve provided good forecasts on certain variables, we’ll be using CAPM for the cost of equity.
Sam: I also want to know, based on these revised calculations, whether TetrraInk should raise the required financing exclusively through the sale of common shares or whether it should raise the funds in proportion to the weights in the current capital structure.
Maya: We can examine these two alternatives and provide the calculations to support our final recommendation. You will then be able to show these to the board to help with the final decision.
Sam: If we proceed with this capital project, I know that one important consideration is the CCA deduction that the company can take to reduce its taxes. The board and I are having some difficulty understanding how the annual CCA deduction compares to the present value of the CCA tax shield used in the capital budgeting analysis. I know you have tried to explain this to us in the past. I was wondering if you could use the new equipment that we intend to purchase to show us the difference?
Maya: Yes, we can do that. I think the best way is to first show you what the CCA tax shield will be on an annual basis over the five-year planning horizon for the project. We can then compare this to the present value of the CCA tax shield associated with this equipment assuming the half-year rule and explain why there is a difference.
Sam: I think using a specific example will make this clearer for us. Finally, I would like to help the board in making the decision about whether we should proceed with this capital project or not. One of the first things that the board likes to see when it starts to decide on any capital project is a payback period analysis because for our company, liquidity is such an important issue. We simply can’t undertake projects that take a long time to generate positive cash flows. Please make this analysis to provide the board with a preliminary sense of the project’s viability. For this calculation, assume that the company will need to increase its net working capital balance by $25,000,000.
Maya: Yes, that will be relatively easy to add to the report especially given that we will already be calculating the CCA figures. I think it’s safe to assume that the cash flows will occur evenly throughout the year for calculating the payback period. Well, we better get started because there is a lot of work to do. Sam, we will get this report to you as quickly as possible.
Make a draft report on the preliminary analysis for Sam on the issues discussed in the meeting. Your solution does not need to be in a formal report format. It can address each issue identified in the discussion above as a separate numbered item.
(Appendix Forecasted data)
TetrraInk’s investment banker has forecasted the following consequences of reducing the company’s financial leverage.
The yield on TetrraInk’s long-term debt would fall to 4.50%
The yield on its preferred shares would fall to 6.75%
The beta on its common shares would fall slightly to 1.1 and its price would rise to $43.50 per share with the announcement of the proposed capital expenditure program and the new issue of common shares. After flotation costs of 7%, TetrraInk will receive $40.455 per share.
Note that the risk-free rate of return is 2% and the market risk premium is 6%.
The investment banker is currently unsure how the expected growth rate for dividends would change.