1 Master of Business Administration Strategic Investment Management Assignment Date for Submission: 21st January 2013 2 Assignment Brief As part of the formal assessment for the Master of Business Administration you are required to submit a Strategic Investment Management assignment. Please refer to your Student Handbook for full details of the programme assessment scheme and general information on preparing and submitting assignments. Learning Outcomes After completing the module the student should be able to: 1. Identify key models and use them to calculate the cost of capital, adjusted present value (APV), and lease versus borrow to buy; 2. Evaluate the importance of the concepts of capital structure and risk management strategies; 3. Undertake strategic investment decisions using a range of methodologies; 4. Critically appraise the strengths and weaknesses of a number of investment decision techniques; Date for Submission: 21st January 2013 Assignment Task Jonathan Digby-Jones had recently been appointed as Chairman of Zinotronics plc, on the resignation of Sir Richard Stanton who had successfully directed the company for the past twenty years, into a relatively successful business in its sector. Jonathan Digby-Jones was quite young for a chief executive, but had been chosen for his drive and enthusiasm, and was seen as someone who would grow the company. At the beginning of a new year the Chairman thought that some important issues needed to be discussed and resolved. He therefore convened a meeting of the Board of Directors in the second week of January, to explore three areas that he had highlighted as being instrumental to the growth and financial stability of the company. The first item on the agenda was one that Jonathan Digby-Jones felt needed particular airing. He was quite concerned that new investment projects had been discounted using a single company wide weighted average cost of capital (WACC) when different projects might have different risk profiles, and that they might have been financed by different capital structures than those for the company as a whole. He was particularly interested in this problem, in view of the fact that a new product proposed by Janine Carter, the Marketing Director, was being brought before the Board for approval. The new product was greeted by all members with enthusiasm, but the subsequent discussion concerned the financing of the project and the subsequent choice of discount rate in order to determine the financial viability of the investment. In order to determine the present company-wide weighted average cost of capital (WACC) the Financial Director, Samuel Banda, provided the meeting with the following information. 3 Balance sheet as at January 2013 £m £m Fixed assets 1,511 Current assets 672 Current liabilities 323 349 Total assets less current liabilities 1,860 7% irredeemable debentures 300 9% debentures (redeemable January 2020) 650 9% bank loans 560 1,510 350 Ordinary shares (50p) 200 Reserves 150 350 The Board was also given the following information: Yield on government Treasury bills 7% Company equity beta 1.21 Market risk premium 9.1% Current ex-div ordinary share price £2.35 Current ex-interest 7% debenture market value £0.66 Current ex-interest 9% debenture market value £105 Corporate tax rate 30% The investment involved in the project under consideration would amount to £125 million, which would give a perpetual stream of cash flows of £16 million per year pre-tax. It is proposed that the investment is financed with an £8.8m issue of 10% debt capital and the remainder in equity. As the new product under appraisal is aimed at the same market sector that the company is mostly engaged in, it was felt that the project would carry the same risk profile as that for the company in general. Sonja Erskine, the Production Director, thinks that as the risk profiles are unchanged by the new investment, the current company-wide WACC could be used as the discount rate to calculate the NPV of the project. However, Samuel Banda disagreed stating that although the risk profile might stay the same, the project is to be financed with a lower financial leverage than that of the company. “Surely the WACC would need to be changed for this particular project if we are to use an appropriate discount rate”, he maintains. The Chairman agrees with his Finance Director and asks how an adjusted WACC rate could be calculated. Recollecting his MBA studies, which Samuel Banda had studied comparatively recently, he states that an Adjusted Present Value (APV) approach to the project appraisal, would overcome the difficulties of different gearing ratios. 4 It was decided that Samuel Banda would carry out the necessary calculations and bring the results back to the Board for subsequent discussion. The Chairman then moved on to the second item on the agenda. He asked Sonja Erskine, the Production Director to brief the board regarding the replacement of their technology systems. Sonja Erskine stated that after considerable research and careful analysis her department, in conjunction with the Finance Director, had narrowed down the decision to two options. The technology system would cost £200 million and would have a zero scrap value at the end of its estimated six-year life. Samuel Banda suggested that the system could either be bought outright through a £150m term loan at 10% interest, secured against the machine, plus £50m of retained earnings. Alternatively, the system could be acquired through a financial lease, requiring six payments of £35m, payable at the start of each year. The Financial Director also expects the corporate tax to still be 30%, payable 12 months in arrears. The company expects to have a corporate tax liability throughout the next five years. Writing down allowances of 25% on the reducing balance is available on capital expenditure. In addition, Sonja Erskine mentions that if the system is bought outright, maintenance costs of £250,000 per year will be incurred. These costs would not be incurred if the computer is leased. Janine Carter, the Marketing Director was of the opinion that leasing would be a better option as it was an off-balance sheet item, and would subsequently not affect the gearing of the company. However, Samuel Banda pointed out that a finance lease is effectively a form of borrowing, and should be taken into account when calculating gearing. Jonathan DigbyJones remarked that he had read a recent article advocating that companies, by integrating a sensible gearing into their capital structure, can minimise their weighted average cost of capital. The Chairman also pointed out that there were many advantages to leasing, such as the servicing of equipment is undertaken for you. Sonja Erskine, however, pointed out that if you bought the computer system, you owned the equipment, and you could sell them at the end of their useful lives, and recoup some of the costs. “There are of course tax implications involved with both options which we must also take into consideration”, commented Samuel Banda. “For example, the maintenance costs give rise to tax relief, a point which is often overlooked.” After a lively discussion covering the advantages and disadvantages of leasing over purchasing it was decided that Samuel Banda should carry out a Net Present Value appraisal of both options and bring the result back to the Board. The third and final item on the agenda was an exploratory discussion on the company’s risk management regarding its interest rate and foreign exchange rates exposure. This was an area that the Chairman was particularly interested in, as he thought that there did not seem to be a coherent strategy in place at the moment. Janine Carter agreed with the Chairman’s concern, as potential expansions into new markets overseas, would necessitate more borrowing and also transactions in foreign currencies. Samuel Banda stated that various interest rate and exchange rate exposures had been hedged against in the past, but these 5 had occurred very much on an ad-hoc basis. He felt that to guard against such things as bankruptcy risk and volatility of cash flows, a coherent risk management strategy was essential. Jason Fairchild, the Human Resources Director, felt that caution was necessary as he had heard that various hedging instruments, such as derivatives, were costly and complicated to implement. Sonja Erskine had read that ‘options’ and ‘swaps’ were essential in hedging against interest rate and exchange rate risk. Samuel Banda felt until an audit of all debt instruments had been made to determine the type and maturity of interest rates, as well as the exchange rates, it would be difficult to determine which type of hedging instrument would be suitable for which type of exposure. After further discussion the Chairman asked Samuel Banda to conduct a suitable audit of exchange rate and interest rate risks, and to make suitable recommendations as to the best hedging techniques to be used, and bring the findings back to the next Board meeting. 6 Section A (1) Calculate the company’s weighted average cost of capital (WACC) using market weightings. (4) (2) Use an adjusted present value (APV) approach to appraise the new proposed investment. Assume that the current gearing ratio, before the new proposal was introduced, is 2:3 (debt-equity) and that the required return on debt and equity is 9% and 18% respectively. (8) (3) Briefly evaluate adjusted present value (APV) as a means of appraising capital investment projects. (8 marks) (4) Critically discuss the comment made by Jonathan Digby-Jones that companies, by integrating a sensible gearing into their capital structure, can minimise their weighted average cost of capital. (20) Section B (5) Using the information provided by Sonja Erskine and Samuel Banda make appropriate calculations to determine whether, on financial grounds, Zinotronics plc should lease or buy the new computer system, and briefly comment on your findings. [10 marks] (6) Critically discuss what other factors may influence the decision of Zinotronics plc to lease or buy the new computer system, apart from financial considerations. [10 marks] (7) Critically appraise the reasons for the popularity of leasing as a source of finance. [12 marks] Section C (8) Compare options with swaps as instruments to hedge against a company’s interest rate risk. Explore the advantages and disadvantages associated with each of these hedging techniques. [15 marks] (9) Appraise whether Zinotronics plc needs a formalised risk management strategy. Explore the advantages and disadvantages of risk management to an organisation. [13 marks] 7 Grading Criteria Grade Criteria > 69% Clear grasp of the calculation and interpretation of WACC, APV and Lease versus borrow to buy. Good understanding of the importance of optimal capital structure, risk management strategies, and the use of options and swaps as hedging techniques Extensive integration of theory and examples Substantial evidence-based conclusions Evidence of wide reading around optimal capital structures, riskmanagement techniques and the use of options and swaps as hedging techniques. 50 – 69% Sound grasp of the calculation and interpretation of WACC, APV and Lease versus borrow to buy. Sound understanding of the importance of optimal capital structure, risk management strategies, and the use of options and swaps as hedging techniques Sound integration of theory and examples Sound conclusions Reading goes beyond basic module content 40 – 49% Basic grasp of the calculation and interpretation of WACC, APV and Lease versus borrow to buy. Basic understanding of the importance of optimal capital structure, risk management strategies, and the use of options and swaps as hedging techniques Basic integration of theory and examples Conclusions needed more depth and supporting evidence Reading appears to be limited to module content. and Lease versus borrow to buy. Little understanding of the importance of optimal capital structure, risk management strategies, and the use of options and swaps as hedging techniques Minimal integration of theory and examples Weak or no conclusions. Incomplete knowledge of module content. Assessed outcomes 1,2,3,4 8 Guidelines: You MUST underpin your analysis and evaluation of the key issues with appropriate and wide ranging academic research and ensure this is referenced using the Harvard system (See ‘Referencing Guide’ in the Study Skills Guide in My Resources). You must use the Harvard referencing method in your assignment. Further Information Word Count: 4,000 words (maximum) The word count excludes the title page, executive summary, reference list and appendices. Where assessment questions have been reprinted from the assessment brief these will also be excluded from the word count. ALL other printed words ARE included in the word count. Printed words include those contained within charts and tables. See ‘Word Count Policy’ in My Resources for more information. Assignments submitted late will be marked as a 0% fail, unless you have withdrawn your intent to submit for this module in advance of the deadline. Your assessment should be submitted as a single word or pdf file. For more information please see the “Guide to Submitting an Assignment” document available on the module page on ilearn. You must ensure that the submitted assignment is all your own work and that all sources used are correctly attributed. Penalties apply to assignments which show evidence of academic unfair practice. (See ‘Dealing with Plagiarism’ in the Study Skills Guide in My Resources).