MANAGING FINANCIAL RESOURCES AND DECISIONS
ACME Corporation is one of the world’s leading manufacturers of steel and steel products. It is headquartered in Germany. ACME is considering setting up a steel structural plant in UAE to cater to the rapidly growing real estate market in the GCC.
It envisages setting up a factory with a capacity to manufacture 100,000 tons per annum. The total cost of the factory is estimated at US$ 175 million. The details of the project cost of US$ 175 million are as under:
- Land : 4 million
- Buildings : 26 million
- Plant & Machinery : 95 million
- Furnitures & Fixtures : 18 million
- Pre-operative Expenses : 15 million
- Working capital margin : 17 million
ACME, itself, is considering an equity investment of US$ 50 million and seeks to raise the balance from outside sources. Its global capital structure policy is to have a maximum debt:equity ratio of 1:1 (50% debt and 50% equity). Further, you are told that ACME’s desired rate of return on any of its investment is 10% on a post-tax basis.
ANSWER BELOW QUESTIONS BASED ON ABOVE SCENARIO
- List out all the possible sources of finance that you believe would be available to ACME to finance the project in UAE. (The options detailed by the student for setting a project in the UAE must bring aspects of Islamic Finance too along with the current sources of finance
- Give a brief analysis of each of the sources of finance along with its advantages and disadvantages. Your analysis should ideally cover among others, factors such as key terms, cost in a qualitative and comparable terms, riskiness, security conditions, tax benefits, tenor etc. You may conduct appropriate research to answer the questions. Please ensure you indicate all your sources of information wherever applicable.
- Based on the information provided and ACME’s internal conditions and policies, discuss what would be the appropriate for financing ACME’s project requirements. You answer should provide a break-up of how US$ 175 million will be financed giving a justification of appropriateness of each of the sources used by you. ACME’s global capital structure policy is to have 1:1 debt:equity ratio which means it will raise 50% of its capital requirements through debt finance and 50% through equity finance. The total cost of the factory is $175 million which means 87.5 million dollars each is needed to be raised through debt and equity finance. To elaborate, debt financing is borrowing from external sources in the form of loans from banks and other financial institutions and equity financing is money sourced internally by the business. Since ACME is investing $50 million from equity finance, it will have to issue shares for the balance amount and this aspect forms the genesis of meeting the AC requirements.
LO 2 – Understand the implications of finance as a resource within a business
ACME has now sought proposals from various finance providers so as to evaluate the optimal financing structure for its project. It is keen to look at mix of debt and equity sources so as to achieve its target debt : equity financing mix. You are told that ACME tax rate will be 30%.
The following proposals have been received by ACME.
- Debt Option 1: Bank A has offered a five year loan of up to US$ 100 million carrying an 8% interest payable quarterly. The principal has to be repaid in semi-annual installments.
- Debt Option 2: Bank A has offered an alternative option of a 4 year loan of up to US$ 95 million carrying interest rate of 7% payable quarterly. The principal has to be repaid in semi-annual installments. ACME would be required to keep a compensating balance of 5% of initial loan amount, till the loan is fully repaid, which would earn an interest of 2% p.a.
- Debt Option 3: Leasing Company B has offered a 5 year lease of plant and equipment of about US$ 85 million on which it would charge a lease rental equivalent to 9% p.a.
- Equity Option 1: An Investment Company is keen to invest up to US$ 50 million in the equity of the company. It has mentioned that the current market conditions offer it enough opportunities to earn a return of 12% p.a.
Given the above information, please help ACME answer the following questions. To get full credit, you are required to show the steps and workings.
- What is the effective interest cost of Debt Option 2? Prepare a table which lists out all the financing options, maximum amount offered, after tax cost. Based on this table advise ACME as to how should it finance the requirements of US$ 175 million, given its debt: equity policy and its own desired investment of US$ 50 million. Please briefly justify why you consider your suggestion as optimal in terms of cost.
- 2 ACME also wants your help to understand the impact Taking a 7 year loan vis-à-vis a 3 year loan, both re-payable semi annually on its future financial performance, as would be seen in its financial statements, once it becomes operational.
ACME Corporation is setting up steel structural plant in UAE to cater to the rapidly growing real estate market in the GCC. It envisages setting up the project at a cost of US$ 175 million. The details of the expected cash flows for the first 5 years are as under:
- Original Investment (year 0) : -175 million
- Cash Inflow (year 1) : +30 million
- Cash Inflow (year 2) : +50 million
- Cash Inflow (year 3) : +80 million
- Cash Inflow (year 4) : +90 million
- Cash Inflow (year 5) : +110 million
The project will be funded by a mix of debt and equity such that the weighted average cost of capital if 10%.
- Given the above information, evaluate the optimal pricing strategy. (AC 3.2 Explain the calculation of unit costs and make pricing decisions using relevant information)
L O3. Be able to evaluate the financial performance of a business based on below.
ACME’s steel project has recently completed 3 years of operations. Key highlights of the financial performance of the company for the last two years are given below. All figures in US $ Millions
|Equity & Liabilities||2011||2012||Assets||2011||2012|
|– Share Capital||50||50||– Net Fixed Assets||95||100|
|– Retained Earnings||60||70||– Intangible Assets||10||10|
|Non Current Liabilities||50||60||– Long Term Investments||10||10|
|– Long Term Loans||41||50||Current Assets||115||140|
|– Employee Benefits||9||10||– Cash||15||20|
|Current Liabilities||70||80||– Marketable Securities||10||10|
|– Bank Borrowings||45||50||– Inventories||40||50|
|– Payables||25||30||– Receivables||50||60|
|Total Equities & Liabilities||230||260||Total Assets||230||260|
|Less : Cost of Goods Sold||(45)||(60)|
|Less : Selling & Distribution Expenses||(6)||(8)|
|Less : General & Administration Expenses||(5)||(6)|
|Less : Interest||(4)||(6)|
|Add : Other Income||–||4|
|Profit Before Tax||20||24|
|Profit After Tax||14||16|
The equity capital of US$ 50 million comprises of 50 million shares of a par value of US $1 per share. During the years 2001 and 2012, the company declared and paid out dividends of US$ 4 million and US$ 6 million respectively.
- Calculate the following ratios for both the years. As an approximation, You may use end of the year numbers instead of average, wherever required
- Earnings Per Share
- Dividend Pay-out Ratio