Scenarios It is 31th December 2019. Your team of four people form a financial analysis team at Aussie Finance Consulting (AFC), a renowned financial institution. The executive management of AFC has assigned you a task to carry out a special project for its client Yarra Digital Limited (YDL), which requires preparing a business report. This report will be presented to AFC executive management and also to the senior management of YDL. YDL is a Victorian pay television companyoperating in cable television, direct broadcast satellite television, and IPTV streaming services. It was formed in 1999 through a joint venture established between Yarra Broadcasting Corporation and Ultra Digital Network Limited, with Yarra Broadcasting Corporation being the 65% and Ultra Digital Network the 35% shareholders respectively. They provide a full range of television services to corporate and government customers including pay TV, data networks and mobility services through a range of carriers offering choice, control and cost reduction. YDL has been in the business for 20 years now. It is well established and profitably running business thus far. YDL has recently undertaken a market study which costed them $50,000. Findings of the study indicate that it is critical for YDL to upgrade their infrastructure to meet the demand of its customers. They plan to do the upgrade systematically in stages gradually over next few years. They also need to plan their finances to fund the upgrade plan. For the upgrade, they need some critical hardware components. The management has identified two options: (1) In-house production which requires the company to establish their own production facility; and (2) Outsourcing which implies external procurement of the necessary hardware. After a careful analysis, the management has worked out the following details for the two options: Option 1: In-house production The purchase and installation of the machinery shall cost $3,500,000 and has an economic life of twelve years. The machinery is expected to depreciate to zero on a straight-line basis over its economic life. However, the company expects to keep their in-house production for only seven years. At the end of Year 7, the machinery can be sold at an estimated market value of $1,700,000. Currently YDL has a warehouse which generates a rental income of $200,000 each Page 3 of 10 year. To save on investment costs, the management intends to convert this warehouse into a factory for manufacturing various hardware components. The conversion cost is estimated to be $140,000 and treated as a capital expense. YDL also requires training its staff on the new machinery immediately after the installation. Training fees are expected to be $10,000 and fully tax-deductable. Annual maintenance cost of the machinery is $160,000. The collective cost of the hardware components to be manufactured is estimated to be $1,800,000 in Year 1 with an expected increase of 4% per annum in the following years. YDL also needs to invest in necessary development software and maintain the licenses. The negotiated licensing fee for the software is estimated to be $57,000 per year. Finally, the management estimates that they shall need additional net working capital of $30,000 at the beginning of the production with an expected increase of 3% per annum in the following years. Option 2: Outsourcing Alternatively, YDL can contract with a firm named Innovative Equipment Limited (IEL) which is specialised in manufacturing the required hardware. Based on the types and expected number of units YDL would need, IEL management has quoted a total cost of $3,100,000 in Year 1 which will continue to grow at 6% per annum to keep up with the rising cost and forecasted growth in the number of the required units. IEL, however, has offered this rate on a condition of a five-year contract. Also, IEL requires that YDL pays 50% of the expected cost for a year in advance at the beginning of that year. From the accounting perspective, equipment that are procured from IEL may be classified as cost of goods sold in the books of YDL. Hence, they will be treated as operating expense for the business. Furthermore, as in Option 1 YDL still needs the warehouse to store the hardware. You are required to analyse the two given options and make recommendations to YDL about the option they should choose.

For the purpose of the analysis, you have already assembled the following information:

Balance Sheet of YDL as of 31 December 2019
Assets
Cash at bank	$ 700,000
Accounts receivable	$ 550,000
Inventory	$ 1,700,000
Marketable securities	$ 6,670,000
Plant, machinery and equipment	$ 150,500,000
Intangible assets	$ 40,000,000
Land and building	$ 30,000,000
Total	$ 230,120,000
Liabilities
Accounts payable	$ 300,000
Bank overdraft	$ 670,000
Commercial bills (due 30th Jun 2020)	$ 3,000,000
3.75% Coupon bonds (due Dec 2029 issued @$100 each)	$ 150,000,000
Shareholders' Fund
Common stock 33,500,000 @ $2.209 each	$ 74,000,000
Retain earnings	$ 2,150,000
Liabilities + Shareholders' Fund	$ 230,120,000

End-of-month stock prices for the market (All Ordinaries Index) and YDL adjusted for all corporate actions such as dividends and stock splits over the previous five years are provided in the file:

Additional Information:

• The applicable interest rate on bank overdraft is 5.5% per annum and has monthly compounding.
• The commercial bills are currently yielding 4.5% per annum with quarterly compounding. They will mature on 30th June 2020 however, will be replaced by newer issues on that date.
• The bonds are currently priced at $102 each and pay coupons semi-annually on 30th June, and 31st December.
• The coupon payment due to be paid on 31th December 2019 has been paid.
• The applicable company tax rate is 30% and the proportion of tax collected from the company and is claimed by shareholders is 0.50.
• The current yield on Australian Government 10-year bonds is 1.40% per annum.
• The expected market return including franking premium is 9.25% per annum.

Requirements

You are required to advise the company on the following:

1. Capital Budgeting Decision (30mark)
2. 1. Which of the two options should YDL pursue?

Steps in part (a):

The first part of the analysis requires you to work out the Weighted Average Cost of Capital (WACC) for YDL with the help of the given information and given data. (15mark)

Secondly, evaluate the two options using NPV analysis and clearly identify which of the two alternatives is better for YDL.(15mark)

1 2 m st U UI m U 1 3 st UI UI 7 3 m 1 Date YDL 31/12/14 31/1/15 28/2/15 31/3/15 30/4/15 30/5/15 30/6/15 31/7/15 29/8/15 30/9/15 31/10/15 28/11/15 31/12/15 30/1/16 27/2/16 30/3/16 29/4/16 28/5/16 29/6/16 30/7/16 30/8/16 29/9/16 29/10/16 29/11/16 30/12/16 28/1/17 28/2/17 31/3/17 29/4/17 31/5/17 30/6/17 29/7/17 31/8/17 30/9/17 31/10/17 30/11/17 30/12/17 31/1/18 28/2/18 31/3/18 28/4/18 31/5/18 30/6/18 31/7/18 31/8/18 29/9/18 31/10/18 30/11/18 29/12/18 31/1/19 28/2/19 30/3/19 30/4/19 31/5/19 29/6/19 31/7/19 31/8/19 28/9/19 31/10/19 30/11/19 31/12/19 All Ordinaries Index 4.62 5388.6 5.03 5551.6 4.93 5898.5 4.99 5861.9 4.93 5773.7 4.92 5774.9 4.86 5451.2 5.14 5681.7 4.57 5222.1 4.56 5058.6 4.39 5288.6 4.36 5218.2 4.56 5344.6 4.58 5056.6 4.27 4947.9 4.33 5151.8 4.49 5316 4.68 5447.8 4.66 5310.4 4.83 5644 4.4 5529.4 4.46 5525.2 4.29 5402.4 4.35 5502.4 4.39 5719.1 4.31 5675 4.15 5761 4.02 5903.8 3.76 5947.6 3.92 5761.3 3.83 5764 3.65 5773.9 3.27 5776.3 3.24 5744.9 3.28 5976.4 3.18 6023.5 3.37 6167.3 3.4 6146.5 3.11 6117.3 2.98 5868.9 3.02 6071.6 2.65 6123.5 2.48 6289.7 2.69 6366.2 2.94 6427.8 3.1 6325.5 2.99 5913.3 2.85 5749.3 2.77 5709.4 3.02 5937.3 3.04 6252.7 3.28 6261.7 3.33 6418.4 3.6 6491.8 3.8 6699.2 3.92 6896.7 3.67 6698.2 3.51 6800.6 3.49 6772.9 3.86 6948 3.54 6802.4 2 m 4 in US m m 2 m st U in m U 2 3 7 in m 2 1 2 m st U UI m U 1 3 st UI UI 7 3 m 1 Date YDL 31/12/14 31/1/15 28/2/15 31/3/15 30/4/15 30/5/15 30/6/15 31/7/15 29/8/15 30/9/15 31/10/15 28/11/15 31/12/15 30/1/16 27/2/16 30/3/16 29/4/16 28/5/16 29/6/16 30/7/16 30/8/16 29/9/16 29/10/16 29/11/16 30/12/16 28/1/17 28/2/17 31/3/17 29/4/17 31/5/17 30/6/17 29/7/17 31/8/17 30/9/17 31/10/17 30/11/17 30/12/17 31/1/18 28/2/18 31/3/18 28/4/18 31/5/18 30/6/18 31/7/18 31/8/18 29/9/18 31/10/18 30/11/18 29/12/18 31/1/19 28/2/19 30/3/19 30/4/19 31/5/19 29/6/19 31/7/19 31/8/19 28/9/19 31/10/19 30/11/19 31/12/19 All Ordinaries Index 4.62 5388.6 5.03 5551.6 4.93 5898.5 4.99 5861.9 4.93 5773.7 4.92 5774.9 4.86 5451.2 5.14 5681.7 4.57 5222.1 4.56 5058.6 4.39 5288.6 4.36 5218.2 4.56 5344.6 4.58 5056.6 4.27 4947.9 4.33 5151.8 4.49 5316 4.68 5447.8 4.66 5310.4 4.83 5644 4.4 5529.4 4.46 5525.2 4.29 5402.4 4.35 5502.4 4.39 5719.1 4.31 5675 4.15 5761 4.02 5903.8 3.76 5947.6 3.92 5761.3 3.83 5764 3.65 5773.9 3.27 5776.3 3.24 5744.9 3.28 5976.4 3.18 6023.5 3.37 6167.3 3.4 6146.5 3.11 6117.3 2.98 5868.9 3.02 6071.6 2.65 6123.5 2.48 6289.7 2.69 6366.2 2.94 6427.8 3.1 6325.5 2.99 5913.3 2.85 5749.3 2.77 5709.4 3.02 5937.3 3.04 6252.7 3.28 6261.7 3.33 6418.4 3.6 6491.8 3.8 6699.2 3.92 6896.7 3.67 6698.2 3.51 6800.6 3.49 6772.9 3.86 6948 3.54 6802.4 2 m 4 in US m m 2 m st U in m U 2 3 7 in m 2