Advanced Financial Management

1. Students canform study groups to complete this assignment.

• A group can have a maximum of four members (1, 2 or 3 are also OK).
• A group of oneis allowed (if you prefer submitting an individual assignment).
• No mark will be awarded if the group has more than four members.

2. The cover page of the assignment should include names and student IDs of ALL group members.
3. NO names can be added to a submitted assignment.
4. Each study group should hand in a single finished assignment. Everyone in the group gets the same mark.
5. No late submission will be accepted.Group break-up will not be accepted as an excuse for late submission.
6. All supporting work and analysis should be presented in clearly numbered appendices, where the appendix number corresponds to the question number. Your answer in the main text should be supported by numbers, facts from the supporting work and analysis, or strong economic arguments, marks will be deducted if appendices are missing.
   

Question 1(30 marks) WACC

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It is 5pm on 27^th April 2016. You are an intern with an investment fund and working hard to support your colleagues on various tasks. You are keen to demonstrate skills acquired from your finance course to increase the chance to be offered a permanent position. A colleague, Sanjay, is building a model to value Meridian Energy and needs your help to estimate the weighted average cost of capital (WACC).  Common practice in this fund is to estimate beta by regressing 5-year monthly total returns to a stock on the monthly total returns to the NZX All index portfolio. However, Meridian has been listed for less than five years. Sanjay suggests that you estimate the equity beta of Contact Energy and use it to derive Meridian’s equity beta. Handing over a dataset that contains the adjusted closing prices of Contact Energy and the levels of NZX AllIndices at the monthly frequency over the past 5 years (see worksheet “Q1” in the Excel file FIN351_2016FC_Assignment2_Data.xlsx), Sanjay asks you to come up with the WACC estimation for Meridian and supply him the sources of information and workings.  You are keen to prove that you can work independently on this task.

• Contact Energy’s Equity Beta. (5 marks).The Excel file contains three time series. They are adjusted closing prices on 27^thof each month of Contact Energy,the NZX All price index and the NZX All total return indexover the past five years, sourced from Datastream. Both the adjusted closing price series and the total return index series include dividends declared during each period. Choose the correct index series to derive the return to the market portfolio, as well as deriving the total return to holding Contact Energy shares. Then, estimate the equity beta of Contact Energy using two different methods. Method one is regression analysis. Method two is fitting a straight line on a plot chart with the equation showing. Print out the regression output and the plot chart and attach them to your solution as Appendix 1(1).Record your answers to four decimal places. Write down your final answer in the cell below.

• Meridian Energy’s Equity Beta (15marks).Go to “Yahoo! New Zealand Business & Finance” (https://nz.finance.yahoo.com/) and search for information that you can use to un-lever the beta of Contact Energy and re-lever it to obtain Meridian Energy’s equity beta. The tickers for these two firms are CEN.NZ and MEL.NZ. Estimating Meridian Energy’s equity beta involves four main steps. First, obtaining the market capitalisation of each firm as of 27^th You need to input the ticker of each firm in the “Look Up” box and click enter to go to the main Yahoo!Finance web page of each firm. Click on “Historical Prices” on the left hand side of the page and obtain the closing price (“Close”) on 27^th April 2016. Click on “Key Statistics” on the left hand side of the page and obtain total number of shares outstanding from the right-hand-side of the page (“Shares Outstanding”). Second, obtain the book value of net debts from the most recent balance sheets. Third, un-lever the beta of the comparable company (CEN.NZ in this case) to obtain the asset beta. Fourth, re-level the industry asset beta to the leverage ratio of company that you are valuing to obtain its equity beta. Record your answer in the table below. Show your answers to debt ratios and betas to four decimal points and other answers to two decimal points.

• Cost of Equity of Meridian Energy (5 marks). Assume that the risk premium for New Zealand stock market is 5% p.a.. Go to the NZX debt market website for all traded bonds (https://www.nzx.com/markets/nzdx/bonds) to obtain New Zealand risk-free rate as of 27^th Scroll down the window to find the government bond with the longest maturity (GOV410). Access the link to this bond, scroll down the window and click on the button “Load interactive chart” on the chart titled “Yield History”. Now you can slide the red line across the chart to obtain the yield on 27^th April. Record this yield as the risk-free rate. Apply the capital asset pricing model to estimate the cost of equity of Meridian Energy.

• Cost of Debt of Meridian Energy (2 marks).Assume that if Meridian Energy issues a bond with 10-year maturity now, the bond will have a rating of BBB+. Assume that a NZ$BBB+ bond with 10-year maturity has a spread of 115 bps over the government stock. Estimate the cost of debt of Meridian Energy.

• WACC of Meridian Energy (3 marks). Use the information from previous steps and assume the corporate marginal tax rate to be 28% to estimate the after-tax WACC for Meridian Energy. Show your workings and final answer below:

Question 2(40 marks). The Cross-border Valuation.

Today is 27^th April, 2016. You are a senior financial analyst with IBM in their capital budgeting division. IBM is considering expanding in Australia due to its positive business atmosphere and cultural similarities to the U.S.

The new facility would require aone-off initial investment in fixed assets of $5 billion in Australian andadditional capital investment of 3% of revenueeach year in year 1-4. All capital investments would be depreciated straight-line to zero over five years. Assume thatat the end of the project the sales price of equipment is zero and the tax effect is also zero. First-year revenues from the facility are expected to be $6 billion Australian and grow at 10% per year. The cost of goods sold (COGS) would be 40% of revenue; the other operating expenses would amount to 12% of revenue. Depreciation and amortisation expenses (D&A) are included in COGS and other operating expenses. Net working capital requirements would be 11% of sales and would be required the year prior to the actual revenues. All net working capital would be recovered at the end of the fifth year. Assume that the tax rates are the same in the two countries, and that two markets are internationally integrated, and that the cash flow uncertainty of the project is un-correlated with changes in the exchange rate (hint: you can use the home currency approach to value the Australian business; the home currency is USD). You manager wants you to find the NPV of the project in U.S. dollars using a USD cost of capital of 12%.

You have the following market data:

• Spot exchange rate: AUD1.3174/USD or 1 USD= 1.3174 AUD (as of 27^th April 2016, Bloomberg)
• Yield-to-maturity (YTM) of zero-coupon government bonds (as of 27^th April 2016, Bloomberg and estimates) (Hint: use these as interest rates to derive synthetic forward exchange rates)

• Assume that IBM’s marginal corporate tax rate is 20%.

Requirements:

• In your Excel spreadsheet, create a projection with timeline (from year 0 to 5). Project free cash flows from this project (without considering any financing effects) from year 0 to year 5 in Australian $ (million). Assume that amortisation is zero in all years and that all cash flows occur at the year end. Provide your projection as Appendix 2(1). You should use the template provided on Canvas (Worksheet“Q2” of FIN351_2016FC_Assignment2_Data.xlsx)                                                 (20 marks)
• Compute synthetic forward rates for each of the five years of the project(). Then, use the forward rates to convert the cash flows to U.S. dollars. Provide your worksheet in Appendix 2(2).                              (15 marks)
• Compute the NPV of the project in U.S. dollars using the 12% required return given by your manager. Include your DCF in Appendix 2(3).             (5 marks)

Question 3(30 marks).Valuing an Abandoned Coking Coal Mine.

You are assessing the value of an abandoned coking coal mine in New Zealand, which still have significant deposits. A mining expert’s report suggests that there might be 10 million tonnes of coking coal in the mine still, and that the cost of reopening the mine will be NZD$100 million.Assume that, if the owner decides to develop this mine, the NZ$100 million will be spent at year 0, and all the operational cash flows occur at the end of each year from year 1 to year 10. The annual production is estimated to be 1 million tonnes, and the nominal price of coking coal is expected to increase by 4% per year. (Hint: assume the asset to be a dividend paying stock with a dividend yield of 10%). The price of coking coal per tonnes is NZD$55 and the average cash production cost is expected to be around NZD$50 per tonne at the end of year 1. You can ignore tax and calculate project cash flows as The production cost is expected to grow at 4% per year, once initiated. The annualised standard deviation in asset values of comparable coking companies is 30% (in New Zealand dollar terms), and the 10-yearNew Zealand riskless bond yield is estimated to be 6% p.a..

Requirements:

• Estimate the value of the mine using static NPV analysis. Assume that all cash flows occur at the year end and a Weighted Average Cost of Capital (WACC) of 10%.Show your valuation model as Appendix 3(1).                  (10 marks)
• Estimate the value of the mine based on the Black Scholes Option Pricing Model. Show your detailed steps and result in the main text.                         (15 marks)
• How would you explain the difference between the two values from (1) and (2) above? Answer the question in the main text. (word limit: 60)                                     (5 marks)