Fundamentals of Business Finance Autumn 2016
Group Assignment
Due by 9am Monday 30 May 2016
(Answers to be submitted using the Assignments feature of UTSOnline)
Contributes 20% of your total assessment
1. Costa Group Holdings Limited (hereafter known as “Costa”) ordinary shares are listed on the Australian Securities Exchange following an Initial Public Offering (IPO) in 2015. Costa is a supplier of fresh fruit and vegetables to the major supermarket chains. Their brands include Driscoll’s berries and Blush tomatoes. Costa used part of the IPO proceeds invest in growth opportunities such as a new tomato glasshouse in the NSW regional city of Guyra. This glasshouse became operational in 2015 however, as stated in the investor presentation released to the ASX on 25/02/2016 it is already “operating at capacity”. Costa’s Growth Plan states that they are considering constructing another tomato glasshouse. Growing tomatoes in a glasshouse offers substantial advantages compared to field-grown tomatoes. Key benefits include the ability to grow tomatoes for 52 weeks of the year, crop protection from adverse weather events and temperature control. For these reasons the yield per hectare for glasshouse-grown tomatoes is ten times that for field-grown tomatoes. However, costs associated with the construction of a glasshouse and the annual operating expenses are substantial. Therefore, before Costa decides to invest in a new glasshouse a financial analysis that considers the costs and benefits must be performed to determine if it will contribute to increasing the wealth of Costa shareholders.
2. You are employed in Costa’s corporate finance department and have impressed senior management with your aptitude for financial analysis. This talent was developed through the practice-oriented assignments that you completed at University. You recall how exciting it was learning about listed companies by searching and reading company announcements made to the Australian Securities Exchange (ASX). The Chief Financial Officer (CFO) has asked you to perform a financial analysis of the tomato glasshouse using a purpose-built preformatted EXCEL spreadsheet. The CFO has suggested you liaise with company employees from a variety of different departments to collect the information that is necessary to perform the analysis. You will also search through public documents to identify some of the assumptions that will be required in your financial analysis. Your analysis will be provided to the Board of Directors who will formally decide whether to proceed with the new glasshouse, based largely on your recommendation.
3. The two major expenses associated with constructing a brand new glasshouse are $3 million for site preparation (i.e., excavation and grading) and the capital expenditure of $22 million for the glasshouse structure (excluding irrigation, as explained in paragraph 11). The directors are accountable to the shareholders and so a rigorous financial analysis is necessary to be confident that the investment in the new tomato glasshouse is justified. The following paragraphs contain a substantial amount of information that has been gathered from across the business and it is your job to determine which information is relevant to the analysis.
4. Costa announced on 25/02/16 that it will pay an interim dividend of 3 cents per share. The number of shares “at reporting date” is stated in Note 9 to the half-year accounts.
5. Costa owns a 50-hectare parcel of land on which they plan to construct the new glasshouse. This land is currently leased to a third party for $1.3m each year and the leaseholder is prepared to continue the lease indefinitely. The new tomato glasshouse has been developed by Costa’s Research and Commercialisation centre. Over the last four years this centre has spent $5 million researching and designing the new tomato glasshouse. As section A.8 of the IPO states, “Expenditure on research activity is recognised as an expense when incurred”. There is some debate among management about whether the research expenditure should be treated as an opportunity cost in the analysis to ensure that this money earns an appropriate return or simply classified as an expense.
6. The annual cash sales of tomatoes associated with the new glasshouse depend on the forecasted tomato price and the projected harvest quantity. Therefore, your first job is to determine estimates of these two variables using the following information:
Forecasted Tomato Price
• You first estimate the tomato price per tonne in 2016 by dividing the sales value of tomatoes in 2016 by the volume (in tonnes) harvested.
• The sales value of tomatoes is not given but Section 3.4 of the prospectus states the percentage of 2016 Produce Revenue contributed by tomatoes.
• You also search the prospectus and locate the FY2016 produce revenue figure (Note:
You will need the Pro Forma financial information reported by segment).
• Costa anticipates harvesting 17,360 tonnes of tomatoes in 2016.
• Using the 2016 tomato sales value figure and the 2016 harvest quantity you can then infer the sales price per tonne in 2016. Costa assumes that this price is also the 2016 sales price per tonne for tomatoes grown in the new glasshouse.
• Due to competition and supermarket buyers constantly bargaining for lower prices, Costa assumes that the 2016 tomato price per tonne will then experience price deflation of 2% each year, starting in 2017.
• Sales from Costa’s existing tomato glasshouse are predicted to increase by $1.9m each year compared to the FY2016 figure regardless of whether the new glasshouse is built or not.
Projected Harvest Quantity
• Costa predicts that the new glasshouse will produce 2,500 tonnes of tomatoes in 2017 (i.e., its first year of production). Costa has confidence that the strong historical growth rates in glasshouse-grown tomato volumes will continue in the future. The 2017 harvest volume is predicted to increase by 12% in 2018, 2019 and 2020, and then maintain an annual growth rate of 4% for the remainder of the life of the glasshouse.
7. It costs $3.7 million a year to operate Costa’s Victorian headquarters. With careful management Costa believes they will not require any additional personnel in headquarters if they build the new glasshouse. In any case, the annual headquarters operating expense will increase by just 2% each year.
8. Because glasshouse-grown tomatoes are hand-picked and hand-packed, labour represents the vast majority of Costa’s total operating expenses. Employee expenses related to the existing glasshouse are $9.2 million per annum and are expected to remain constant for the next ten years. Employee expenses for the new glasshouse are forecast to be $5.3m in its first year of operation. With tight cost control Costa believes they can restrict the annual increase in employee expenses associated with the new glasshouse to $800,000 for each subsequent year.
9. Pest control in the new tomato glasshouse can be performed using the existing underutilised equipment in the current glasshouse. The equipment has an annual operating cost of $770,000 per annum, regardless of how much it is used. The accounts department suggests allocating fifty percent of the annual operating cost to the new glasshouse.
10. Costa will evaluate the viability of the glasshouse over a ten-year timeframe. If the glasshouse investment proceeds, $3 million worth of excavation and grading must be paid today to prepare the site for construction. There is some debate about whether this expense should be deferred until the final year of the glasshouse’s life. However, for taxation purposes excavation and grading are defined as a business deduction. Included in the excavation expense is the cost of demolishing the existing storage barn. This barn was purchased in 1994 for $2 million and Costa was depreciating it over a 20-year tax life. The barn has a timber frame construction and a building material recycler is willing to purchase the timber for $85,000 today.
11. Costa is proud of its commitment to sustainable agriculture and plans to make the new tomato glasshouse completely water self-sufficient by capturing rainwater from the glasshouse roof via a $2.4 million irrigation system. However, the entire irrigation system will need to be replaced at the end of its eight-year usable life. Costa has signed a contract with the irrigation installer stating that the system will be replaced at a cost of $2.4 million in 2024. If the system is sold at any point during its life its only value is as $80,000 scrap.
12. Glasshouse-grown tomatoes rely on the irrigation system providing an uninterrupted supply of high quality fresh water. Contaminated water has the potential to destroy an entire crop and so Costa will spend $1.5 million each year on water quality control testing. At the moment Costa’s fixed operating costs are $2m per annum and will not change for the foreseeable future. Once the new tomato glasshouse is operating, Costa’s total fixed costs would rise to $4,300,000 in 2017 and this figure will then increase by 3% each year.
13. One purpose of Costa’s IPO was to repay existing debt enabling Costa to reduce its annual interest expense by $1.7m. Costa will use $17m of cash to finance the new glasshouse and the remainder of the investment will funded through operating cash flow. The financial viability of the project can be improved if Costa uses the cash to partly fund the cost of the new glasshouse. IPO transaction costs of $20.6m are recorded in the 2016 accounts.
14. The Australian Taxation Office (ATO) categorises the tomato glasshouse as an Environmental Control Structure with an estimated twenty-year life for tax purposes. The glasshouse has an estimated value of $6.5 million after ten years and $1.6 million in twenty years’ time. The ATO states the irrigation system has a five-year life for taxation purposes. ATO policy is that all non-current assets are depreciated to zero. For internal management reporting purposes Costa’s policy is to depreciate all assets to zero using a five-year life.
15. In 2014, Costa spent $1 million upgrading the tomato tray-wrapping machine. The machine has a market value of $400,000 and is being depreciated at $125,000 each year. The machine must be retained irrespective of whether Costa proceeds with the new glasshouse or not.
16. If the directors approve the new tomato glasshouse Costa anticipates that it will require an additional $3 million of inventory today on top of the current level of $11.5 million. Currently, accounts receivable are $18 million and you expect that this figure will not change if Costa builds the new glasshouse.
17. Assume the company tax rate is 30% and the required return is 14%.
REQUIREMENTS
Your team must answer the following questions. All answers must be entered into the preformatted EXCEL spreadsheet available on UTSOnline. Questions 1 to 4 require information relating to the capital budgeting decision of the proposed tomato glasshouse. Annual figures for the tomato price per tonne and the quantity of tomatoes harvested from the new glasshouse must be supplied in the designated cells. Question 5 requires you to analyse Costa’s equity and debt securities.
Capital Budgeting Information (15 Marks)
Present an itemised breakdown (and the total) for each of the following:
1. The cash flows at the start.
2. The cash flows over the life.
3. The cash flows at the end.
4. What is the NPV of the new tomato glasshouse?
Equity and Debt Information (5 Marks)
5. a) If you bought Costa shares in the IPO, what is your percentage return assuming you sold the shares today? (“Today” can be any ASX trading day after 1 May 2016. We will confirm your calculation).
b) As announced to the ASX on 04/12/15 Costa was due to be added to the S&P/ASX 200 Index later that month. What is one advantage to Costa’s shareholders of having the company included in the S&P/ASX 200 Index?
c) Costa’s borrowings are in the form of a bank loan and detailed loan information (such as the term, or length) is disclosed in Note 17 of the 2015 Annual Report. The initial loan amount was $250 million as at 30 April 2014 and the term is stated in section 2) of Note 17 (a). Assume that Costa makes the minimum debt repayment as specified in section 3) of Note 17 (a) on 30 May 2016. Further assume that Costa then makes additional monthly repayments of $7 million at the end of each month from June 2016 until June 2018. Given this repayment schedule, what is the outstanding value of the bank loan on the maturity date? Assume the nominal rate for this facility is the current Reserve Bank of Australia ‘Cash rate’ plus a margin of 2.75%, and that this rate is compounded monthly.
SUBMISSION INSTRUCTIONS
Enter your answers into the EXCEL spreadsheet provided under “Assignments” on UTSOnline. This spreadsheet is designed so that the answers to the five questions will fit on one A4 page which speeds up the marking process to give you faster feeedback. The spreadsheet is protected which means that only a restricted number of cells can be used. The cells that you cannot use are coloured grey.
Right click on the link “FBF_Assignment.xlsx” and choose “Save Target As…”.
Open the spreadsheet and enter each team member’s details and the tutorials details of one team member. Marked spreadsheets will be returned in the nominated tutorial only.
Enter your answers to the five questions in the vacant white cells. For Q1, 2 and 3, enter the cash flow description and the dollar amount in the appropriate cells. Use whole dollars only – ignore cents. There are more rows than required, so if you’ve used all the rows then it means you’ve got too many cash flow items. Q4 and Q5 can be answered using the vacant cells provided. Don’t worry if any of your cells appear as “######” because we can view it.
It is your team’s task as aspiring financial managers to sort through the information and correctly identify the relevant cash flows. For this reason, we will not provide direct “yes/no” answers to your UTSOnline questions. We will of course clarify perceived ambiguities.
We will not answer questions by email (email is acceptable only for questions of a private/personal nature). Questions belong on UTSOnline because everyone benefits from your question and the answer (whether the answer is supplied by us or another student).
Any one team member can lodge the case study however it is each team member’s responsibility to ensure the case study has been correctly lodged. Everyone in a team gets the same mark so ensure that all your team members contribute equally.
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