U20478: Giant Tech International Ltd -University Of Portsmouth- Finance And Financial Market Assignment

Finance Assignment:

Giant Tech International (GTI) Ltd is evaluating a proposal to acquire Hyper Chip Ltd, a young company with an interesting new chip technology. This technology, when integrated into existing GTI silicon wafers, will enable GTI to offer chips with new capabilities to companies with automated manufacturing systems. GTI analysts have spent the last three months assessing Hyper and so far have incurred costs of £100,000. GTI analysts have projected income statements for Hyper five years into the future. These projections appear in the income statements below, along with the estimates of Hyper’s asset requirements and accounts payable balances each year. These statements are designed assuming that Hyper remains an independent, stand-alone company. If GTI acquires Hyper, analysts believe that the following changes will occur: 1. GTI’s superior manufacturing capabilities will enable Hyper to increase its gross margin on its existing products to 45%. 2. GTI’s massive salesforce will enable Hyper to increase sales of its existing products by 10% above current projections (for example, if acquired, Hyper will sell £110 million, rather than £100 million, in 2018). This increase will occur as a consequence of regularly scheduled conversations between GTI salespeople and existing customers and will not require added marketing expenditures. Operating expenses as a percentage of sales will be the same each year as currently forecasted (ranges from 10% to 12%). The fixed asset increase currently projected through 2022 will be sufficient to sustain the 10% increase in sales volume each year. 3. GTI’s more efficient receivables and inventory management systems will allow Hyper to increase its sales as previously described, without making investments in receivables and inventory beyond those already reflected in the financial projections. GTI also enjoys a higher credit rating than Hyper, so after the acquisition, Hyper will obtain credit from suppliers on more favorable terms. Specifically, Hyper’s accounts payable balance will be 30% higher each year than the level currently forecast. 4. GTI’s current cash reserves are more than sufficient for the combined company, so Hyper’s existing cash balances will be reduced to £0. 5. Immediately after the acquisition, GTI will invest £50 million in fixed assets to manufacture a new chip that integrates Hyper’s technology into one of GTI’s best- selling products. These assets will be depreciated on a straight-line basis for eight years. After five years, the new chop will be obsolete, and no additional sales will occur. The equipment will be sold at the end of year 5 for £1 million. Before depreciation and taxes, this new product will generate £20 million in (incremental) profits for the first year, £30 million the second year and £15 million in each of the next three years. GTI will have to invest £3 million in net working capital up front, all of which it will recover at the end of the project’s life. 6. Both companies face a tax rate of 34%. GTI’s capital structure contains 83.845% equity and 16.155% debt. The debt finance consists of a 5.6% undated loan stock currently priced at £80 (per £100 of face value) in the bond market. The equity finance consists of ordinary shares with a beta of 1.625. The current rate provided by UK Gilts is 4%, and the market return is 12%. The proposed acquisition will not materially alter the current cost of equity or debt. Questions: a) Estimate the cost for each source of finance GTI uses and the WACC. b) Calculate the present value, as of 2017, of Hyper’s cash flows from 2018 forward. Assume that by 2022 Hyper reaches a “steady state”, which means that its cash flows will grow by 5% per year in perpetuity. What does this NPV represent?! c) Suppose GTI acquires Hyper. Recalculate Hyper’s cash flows from 2018 to 2022, making all the changes previously described in items 1-4 and 6. Ignoring item 5 in the list of changes, what is the present value, as of 2017, of Hyper’s cash flows from 2018 forward? (Assume that by 2022 Hyper reaches a “steady state”, which means that its cash flows will grow by 5% per year in perpetuity). d) Calculate the NPV of GTI’s investment to ingrate its technology with Hyper’s. Considering this in combination with your answer to part (c), what is the maximum price that GTI should pay for Hyper? e) The comment about the suitability of NPV & other methods as a way of appraising investment opportunities.