Sensitivity analysis and capital budgeting

Advanced Corporate Finance

Group Assignment Problem and Instructions


You are a senior recruiter at Best People, a recruitment agency. Mr. David Smith, the chief financial officer (CFO) of Tasman Pulp Mill Co. (TPM), has just announced that he will retire in 6 months after 25 years at TPM. A long-term client of Best People, TPM is a Launcestonheadquartered, ASX-listed company that employs more than 1200 people across its diversified business units in Tasmania, where the overall unemployment rate is above 7.5%.

The chair of the recruitment committee of the board of directors at TPM asks you to help find the next CFO who will be able to assist the chief executive officer (CEO) to continue the success and growth that TPM has seen over the last two decades or so.


You indicate to the committee chair that, because TPM continues to expand its operations via either acquiring other businesses or upgrading current facilities, it is critically important the incoming CFO has thorough understanding of project analysis and capital budgeting. You also suggest that the best way to test the candidates’ knowledge and practical skills is to ask the candidates to analyze a simulated case in addition to the usual formal interview.


Part I (8 marks): The committee chair agrees with you and asks you to come up with a mock case. The information listed below will be given to the candidates.


(1) TPM has an after tax cost of capital of 11%; it will pay 8% on any new bank borrowing; the current tax rate is 30%.


(2) A new manufacturing technology has just become available. Adopting this new technology requires TPM to upgrade its manufacturing equipment. Compared to the existing technology, the new technology is faster and requires fewer workers but at the
same time is less environmentally friendly.


(3) The current pulp mill equipment has an annual output of 600,000 air dried tonnes (ADt) of pulp which currently sells at $125 per tonne. In contrast, the new equipment will have an annual output of 700,000 ADt of pulp. Annual demand is only 600,000 tonnes.


(4) The current equipment was purchased three years ago for $50,000,000. It has a book value of $29,000,000 and another four years of life remaining with no salvage value. It can be sold on the secondary market today for $12,000,000. The new equipment costs $76,000,000 (will be fully funded by bank loans) and is expected to last five years with an estimated salvage value of $16,000,000.

(5) The current equipment requires annual fixed cash costs (including overhead and operating) of $4,250,000, while the new equipment requires $3,790,000.


(6) Manufacturing pulp using the current equipment incurs the following costs (per tonne) in addition to the costs stated in (5): labour $34.5, material $35.5, variable overhead $15.25, and fixed overhead $17.5. The corresponding figures for the new equipment are $18.45, $29.20, $13.55, and $21.25, respectively.

All candidates are required to answer the following questions:


(a) From the perspective of capital budgeting, should TPM upgrade to the new technology or continue to operate using its current equipment?


(b) Conduct a sensitivity analysis) of adopting the new technology by considering specifically (i) that labour cost per tonne may be underestimated, (ii) that demand might be higher than 600,000.


(c) What types of non-financial factors TPM must also consider when evaluating the new technology.


Part II (5 marks): The committee chair also asks you to prepare a list of questions which will be used in the formal interview to test the candidates’ theoretical understanding of project analysis and capital budgeting. The Chair indicates that the number of questions
should be
ten.


The Chair further indicates that the majority on the interview panel have no background in project analysis and capital budgeting; therefore they rely on the answers prepared by you to conduct the interview and select the most suitable candidate for the position of deputy CFO.


Requirements:


For Part I, a full report that consists of the calculation results and the associated analysis is required; a separate Excel spreadsheet showing the necessary calculations and risk analysis is required. For Part II, typed questions attached to the end of the report from Part I is required.


In terms of style and format, the full assignment should be no more than 10 pages excluding references and appendices. You are required to use 12 point font size, 1.5 lines- spacing with standard margins. The font size of the spreadsheet can be adjusted to fit the page. The spreadsheets
CANNOT be placed in the appendices. Up to 2 marks will be deducted if the style and format requirements are not met


Submission:


(1) Both a hard copy and a soft copy need to be submitted. Partial submission (i.e., submitting only a hard copy or a soft copy) will NOT be marked.
(2) Only one full submission is required for each group.
(3) To submit the assignment, you must print out a group cover sheet with a bar code from

(4) Attach this cover sheet to the front of the assignment and take it to Business Central to be scanned and submitted by Wednesday 11 October, 4PM the latest. The assignment will electronically be recorded as “submitted” and an electronic receipt will be issued to your University email account. Please note that you will need to print the coversheet on a laser printer (use the library or computer lab printers if necessary) because ink jet printers may not print to the quality needed to make the barcode readable by the scanners.
(5)
Please ensure that you have signed the plagiarism declaration before submitting your assignment for scanning at Business Central.
(6) The soft copy needs to be submitted via Moodle site. A Turnitin submission link will be provided on Moodle in due course. Submission by direct email to the subject coordinator is NOT accepted and will NOT be marked. Please see subject outline for
more details.
(7) The soft copy is due by
10pm Wednesday 11 October.
(8) Penalty applies to late submissions. 10% of the maximum possible mark per working day or part thereof will be deducted from your mark.
(9) Each group must also complete and submit a record of meetings by completing the
Meetings Journal. This can be attached to the submitted report.
(10) In addition,
each group member, must complete and submit the Confidential Peer Review Form. This must remain confidential to each student (other group members must not see this). Submit this to your tutor in your tutorial in week 11.


Any Questions:


If you have any enquiries regarding the group assignment, feel free to raise your questions during the tutorials or consultation time. You are also encouraged to publish your questions on the Assignment Discussion Forum (A specific link is provided) on the subject Moodle site. However, you are not allowed to discuss your solutions with other groups.

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