Hypothetical company background

You are an analyst working in the finance department of Reliable Ltd. Reliable is a publicly listed car parts manufacturing company that is based in Melbourne. The company is co-founded by two former Formula 1 drivers. Reliable has recently come up with its latest innovation in the catalytic converter, which is used in cars to convert fumes into harmless emissions. The new design loads platinum nanoparticles onto nanofibers and then coats the nanoparticles with silica and an organic pore-generating compound that can be removed by gentle heating. The porous sheath allows gases to reach the platinum but prevents the particles from aggregating. In order to manufacture the new catalyst converter, Reliable needs to purchase new machinery and must decide whether to purchase large or small-capacity machinery. New machinery has an expected life of 9 years, after which salvage values are $300,000 for the large machinery and $160,000 for the small machinery. Market research has estimated that there is a 65% probability that demand will be high throughout the next 9 years and a 35% probability that demand will be low throughout the next 9 years. There is an initial increase in net working capital of $400,000 for the large machinery and $260,000 for the small machinery. The initial outlays associated with the net working capital are recoverable at the end of their useful life. The large machinery is expected to cost $3,000,000, with an extra installation and shipping costs of $100,000. The small machinery is expected to cost $1,400,000, with additional installation and shipping costs of $90,000. The company accounting's policy is to depreciate using the straight-line approach, using 10 per cent on prime cost in each year. In the event of high demand, the company expects a yearly operating revenue of $13,000,000 if it acquires the large machinery, and a yearly operating revenue of $7,000,000 for the small machinery. If the demand is low, yearly operating revenue is forecasted to be $4,000,000 for both the large and small machinery. Annual variable costs associated with operating the machinery are expected to be 70% of the operating revenue for the large machinery and 60% of the operating revenue for the small machinery. In addition, given that Formula 1 driver-endorsed sticker with converter increases sales, the company has decided to endorse uprising top 100 racing car drivers with significant marketability, 'Safe Emission with RCC', at a cost of $1,600,000 per year if the company chooses to proceed with the large machinery. If the small machinery is chosen, the company only has the budget to endorse one of the racers at a cost of $900,000 per year. You have recently evaluated the capital structure of the company and believe that it is operating at the optimal level of 60% equity and 40% debt. The weighted average cost of capital (WACC) from this capital structure is 10.5%. Assume that the tax rate is 30%. You would also like to understand how sensitive your capital budgeting decisions are due to changes in WACC. As such, in addition to determining which machinery to invest in, you want to investigate the effects of WACC on NPV and the cross-over rate of the large and small machinery for the overall outcome.

Required :You are to prepare a report, to present to the CEO, showing (1) the various cash flows based on the different scenarios and (2) the sensitivity analysis using different WACC and the calculation of cross-over rates. Using Excel as your main analysis tool, evaluate whether the company should proceed with the purchase of large or small machinery to manufacture catalytic converters taking into consideration the various scenarios. Based on your analysis, you should also provide recommendations on how the company may be able to further maximise shareholders' wealth by altering the capital structure. Show all workings in the appendix of the report. You should also clearly state any assumptions (if any) made in your analysis.