James McNab Case Study - Northern Construction - Accounting and Finance Assignment Help

Assignment Task:

QUESTION 1 

James McNab recently approached you for advice concerning the investment of proceeds he received from the sale of his business.  Over the last 10 years James had opened a number of coffee and sandwich bars in carefully selected sites in Adelaide that, together with a number of exclusive deals with suppliers, had resulted in a growing and profitable business.  He received $1,500,000 from the sale which, after paying off a few loans, left him with net proceeds of $1,300,000. It was his intention to invest $1,000,000 of these proceeds, and sought your advice on an investment strategy he should employ, and several concerns he had.  First, he wanted to invest some of his funds in a low risk asset to provide some stability in his future returns, and the balance in shares with high earnings growth potential. He was particularly attracted to Mill Industries, a company established by a relative that was expected to generate high future returns.  

After your meeting with James it had been agreed that some of the funds should be invested in a portfolio of corporate bonds managed by a reputable financial institution with an expected return of 9% and a beta of 0.6, and the balance in shares in Mill Industries.  Enquires indicated that stock analysts generally agreed that shares in Mill Industries had an expected return of 13.6% and a beta of 1.2. In response to your questions, James had indicated that he wanted to earn an overall return of 8% on the investment of his money. 

1. How much of his funds would James have to invest in each of these two assets to achieve his return target?

2. What would be the beta of the resultant portfolio?  How should you describe the level of riskiness of this portfolio to James?  

3. Suppose James, after talking to friends, now wants to invest a further $300,000 in shares in Southern Mining to add to his portfolio.  These shares have an expected return of 15% and a beta of 1.5. What would be the expected return and beta of this expanded investment portfolio.

4. Given a risk-free rate of 3.4%, which is the superior portfolio?  Why?

QUESTION 2

New Frontier Investments is a new private equity company that successfully raised $50 million from institutions to invest in early stage innovative companies across a range of industries that had the potential to develop and implement disruptive technologies and strategies.  The company would provide advice and guidance to these companies with a view to floating them on the stock exchange via an Initial Public Offering (IPO) of shares, and to sell down their shareholdings in the companies as part of the IPO. The company currently has investments in five companies that met its objectives.

The company keeps a close watch on its cost of capital given a recent increase in volatility in financial markets.  Currently the company has a beta of 1.4 and estimates the current risk-free rate and the market risk premium to be 2.5% and 6% respectively.  The company is subject to a 30% corporate tax rate and has been fully equity funded since it was established.

The company’s business investment team is currently evaluating a further four potential investment opportunities across four different industries.  Each of the companies are in the early stage of development based on new disruptive strategies, meeting a primary requirement of Baywater. The team has estimated the risk and return measures for these investments, based on beta and the internal rate of return.  This information is as follows:

1. Which of the above businesses should the team recommend for more detailed analysis using the company’s current WACC as the benchmark return?

2. Do you agree with these results?  If not, which businesses would you advise be recommended?

3. The team is aware that New Frontier Investments is planning to change its capital structure from an unlevered to a levered one, and wants to consider the impact of this potential change in capital structure on the company’s cost of capital.  They are aware that the company will shortly issue debt securities at a yield of 9% and use the entire proceeds to re-purchase shares. This will result in a new capital structure of D/V = 0.3. Estimate the company’s WACC under this structure according to the Modigliani and Miller static theory of capital structure.

4. What other factors should be taken into consideration in changing capital structure?

QUESTION 3

Northern Construction, a Whyalla based company, is engaged in the business of installation and refurbishment of urban water and waste pipeline networks based on materials, specialised equipment and installation technology developed inhouse by the company’s R&D team over an extended time-period.  Using the company’s equipment and materials trained installation teams can operate in crowded urban environments with minimal disruption to pedestrian and traffic flows. Moreover, in the case of refurbishment, the pipeline materials can extend the life of old pipelines by up to 30 years. It has been very successful in winning new business in the fringe real estate developments around Adelaide, and also in the development of new copper and iron ore mines in the northern regions of South Australia, and is now actively seeking new projects.

The company was aware of the very substantial investment in urban transport being undertaken or planned by the Victorian Government for Melbourne.  This includes the construction of the West Gate Road Tunnel under the Yarra River to relieve congestion on the Westgate Freeway and also to connect to other major freeways; a rail connection to Melbourne’s Tullamarine Airport; an extension to the suburban train system involving 7 km of twin tunnels under the CBD and several surrounding suburbs plus seven new underground stations; continued removal of up to 50 level crossings across the metropolitan rail network; and extension of the tram/light rail network to new suburbs.

The company is well aware of the substantial pipeline work that would be required on these projects including both new water and waste pipelines and refurbishment of existing ones.  It had participated in a trade exhibition in Melbourne in August 2019 to show case its pipeline installation and refurbishment capabilities and products, and had received strong expressions of interest from some engineering and construction companies to subcontract pipeline projects to the company.  However, it was made clear that the company would need to establish a fabricating plant close to the centre of major works, preferably in Yarraville in the west of Melbourne, if it was to be a preferred contractor for pipeline related works.

Since the trade exhibition the company has moved quickly to assess the feasibility of expanding into Melbourne and operating there for five years.  At the end of this period it is expected that transport infrastructure expenditure will be considerably reduced as major projects are completed. As the senior business analyst of the company, you have been instructed to undertake this assessment, reporting to the CEO in time for it to be considered by the company’s Board of Directors at its January 2020 meeting.  Your team has now been busy on the project for several months and has collected considerable information about potential cash flows the project is expected to generate. In summary, these are as follows:

• Northern Construction had purchased land in Yarraville in January 2017 for $3.9 million as a result of an earlier project to establish a fabricating facility in Melbourne.  Although the company did not proceed with this project, it did decide to invest in land in a newly designated industrial zone in Yarraville as an investment. You have been instructed to consider building a new fabrication plant on this land.  The company recently received a current valuation of $4.4 million for the land. It is anticipated that the land will increase in value at the rate of 5% per annum for the foreseeable future.

• A fabrication plant will cost $37 million to construct including specialist equipment to be acquired from a supplier in Italy, all of which can be depreciated on a straight-line basis over five years for tax.  In addition, at the end of the project’s life the plant and equipment could be scrapped or sold for $20 million. If approved, construction of the plant would commence in March 2020 and be completed by the end of the year.

• Intensive discussions with engineering and construction companies in Melbourne, and further work by your team has estimated that the Melbourne project will generate annual earnings before interest, tax, depreciation and amortisation (EBITDA) of $14,525,000.

The company’s CFO has informed the project team that the company will have to raise new capital to fund the investment in the project consistent with maintaining its existing debt ratio.  The company’s current capital structure consists of the following:

• Debt: 210,000 7.4% coupon secured notes with five years to maturity.  These notes are currently priced at 95% of face value of $100 with half yearly coupon payments.

• Equity: 8,300,000 ordinary shares outstanding currently trading at $6.80 a share; and 2,000,000 preference shares paying a dividend of 9% per annum, and currently trading at $1.10 a share.  Both ordinary and preference shares have a par value of $1 a share.

• Market:  the company’s ordinary shares currently have a beta of 1.1, the market risk premium is 7%, and risk-free rate is 3.5%.

After discussions with the company’s investment bank, the team estimates that the costs associated with raising new capital would be 8% on an issue of ordinary shares, 6% on preference shares, and 4% on a new debt issue.

The CFO considers that this project is somewhat riskier that the typical project undertaken by the company because it involves investing in a new market involving new clients, suppliers, and regulations.  She has instructed you to use a risk adjustment factor of +4% in evaluating the project.

The company tax rate is 30%.

Based on the estimated net present value and internal rate of return for the project, would you recommend to the CEO and the Board that the company undertake this expansion project?

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