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 $10\mathrm{.}5\%.$ 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 maximize

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.