Scenarios

It is 31^stDecember 2018.

Your team of three people is a team of financial consultants at Astute Consultants Everywhere (ACE), a renowned financial institution. The executive management of ACE has assigned you a task to carry out a special project for one of its clients, Excellent Telecommunication Technologies Limited (ETT). This task requires you to prepare a business report which will be presented to both ACE executive management and to to the senior management of ETT.

ETT is a company within the telecommunication industry. It provide communication services (internet, voice, mobile and other related services) for commercial and household purposes throughout Australia. ETT is a well-established and profitable company and has now been in business for 25 years.

ETT is in need of upgrading its infrastructure. It plans to carry out this upgrade of infrastructure systematically in stages over the nextfew years. For the upgrade, it needs some critical hardware components and now must decide as to how to source these components.

ETTs management has identified two options. Option 1 involves in-house production of the required hardware components. This option requires the establishment of a production facility. Option 2 is an outsourcing option, where the necessary hardware will be procured externally.

Already ETT has undertaken some initial work in relation to Option 1. For this option, a plant neeeds to be set up and appropriate machinery installed. ETT has already investigated several available sources of machinery with this preliminary study costing ETT $10,000.

After a careful analysis, the management of ETT has provided the following details for the two options:

Option 1: In House Production

The purchase, delivery and installation of the machinery will cost $1,000,000 and the machinery has an expected life of 4 years. ETT management estimates that ETT shall need additional net working capital of $50,000 for the smoothrunning of the project. The machinery is expected to depreciate to zero on a straight-line basis, andETTs management expects to sell it for the salvage value of $80,000 at the end of Year 4.

Further, to save on investment costs, the management intends to convert a piece of land currently being used as a car parking lot. ETT generated $200,000 last year through parking fees, and these fees have been growing consistently at 2% per annum. The conversion cost is expected to be $25,000 and is to be treatedas capitalexpense.

ETT also requires training of its staff in the use of new machinery. The training will be undertaken during the first year of the project and is expected to be $40,000. The collective variable cost of various components to be manufactured is estimated to be $3,000,000 in Year 1 with an expected increase of 4% per annum each year. ETT will also need to rent a warehouse to store inventory. The cost of renting the warehouse is expected to be $100,000 in the first year with the cost rising by the inflation rate in subsequent years. ETT will also pay an ongoing maintenance feeto the hardware vendor, with the initial annual cost being $150,000 and with this cost rising annually in line with inflation.

Option 2: Outsourcing

Alternatively, ETT can contract with a firm named Reliable Equipment Always Pty Ltd (REA). This firm specialises in manufacturing the required hardware. Based on the types and expected number of units needed by ETT, REA management has quoted a total cost of $2,750,000 in Year 1. This cost is expected to grow by 5% per annum to keep up with the rising cost and forecasted growth in the number of the required units. However, REA has offered this rate on a condition of a minimumof six years of the contract. As well, REA requires that ETT pays 50% of the expected cost for a year in advance atthe beginning of that year. From the accounting perspective, components that are procuredfrom REA need to be classifiedas cost of goods sold in the books of ETT. Hence, the cost of the hardware components will be treatedas an operating expense for ETT. As in Option 1, ETT will need to rent a warehouse.

You are required to analysethe two given options and make recommendations to ETT as to the approach it should take.

As well as requiring the anlaysis of the two options, ETT has asked ACE to provide some information for some of its senior staff. Not all ETT senior staff have a finance background, and so ETT requires your report to include an explanation of key finance ideas that underpin your analyisis of the two options.

Also, as some senior ETT staff do not have sufficient understanding of some of the sources of capital presently used to finance ETT, your report needs to explain, briefly, similarities between preference shares and bonds, and differences between these two types of capital.

To be able to carry out the analysis, the required rate of return needs to be established. For the purpose,you have already assembled the following information from the books of ETT:

Excerpts from the Balance Sheet as of 30th June 2018
Mortgage on buildings @ 4.9% compounding daily	$ 5,500,000
5.2% Coupon Bonds (Due Dec 2028 issued @$1000 each)	$ 50,000,000
5.75% Preference Shares 60,000 @ $100 each	$ 6,000,000
Common stock 50,000,000 @ $1 each	$ 50,000,000

Additional Information:

• The Bonds are currently priced at $1047 each and pay coupons each year on 30^thJune, and 31^stDecember.
• The coupon payments due to be paid on 31 December 2019 have been paid.
• The Preference Shares are currently trading at $101 each.
• The applicable company tax rate is 25%.
• The current yield on 1 Year T-Bills is assumed to be 2.5% per annum.
• The market return is 11.5%
• Because of ACEs previous work in the telecommunications sector, together with its understanding of ETTs capital structure, you may assume that ETTs beta is 0.93
• The current inflation rate is 2% p.a. Over the past 10 years the inflation rate has ranged from 1.9% p.a. to 2.8% p.a.
• Both the inhouse production option and the outsourcing option can be considered as replacement projects.

To carry out this assignment, these are steps you need to undertake:

• Establish ETTs WACC and NPV
• Please round off your values to 4 decimal places for interest rates and twodecimal places for amounts, e.g.0.0659 or 6.59%, and $10,369.78