Siri Bhd. is an engineering company which is involved in projects around the world. It has been growing steadily for several years and has maintained a stable dividend growth policy for a number of years now. The board of directors (BoD) is considering bidding for a large project which requires a substantial investment of RM 400 million. It can be assumed that the date today is 1 March 2018.
The BoD is proposing that Siri Bhd. should not raise the finance for the project through additional debt or equity. Instead, it proposes that the required finance is obtained from a combination of funds received from the sale of its equity investment in a USA company and from cash flows generated from its normal business activity in the coming two years. As a result, Siri Bhds current capital structure of 800 million RM 1 equity shares and RM 700 million 5% bonds is not expected to change in the foreseeable future.
The BoD has asked the companys treasury department to prepare a discussion paper on theimplications of this proposal. The following information on Siri Bhd. has been provided to assist in the preparation of the discussion paper.
1. Expected income and cash flow commitments prior to undertaking the large project for the year to the end of February 2018
Siri Bhds sales revenue is forecast to grow by 8% next year from its current level of RM 3 billion, and the operating profit margin on this is expected to be 15%. It is expected that Siri Bhd will have the following capital investment requirements for the coming year, before the impact of the large project is considered:
-
A RM 0.10 investment in working capital for every RM 1 increase in sales revenue;
-
An investment equivalent to the amount of depreciation to keep its non-current asset base at the present productive capacity. The current depreciation charge already included in the operating profit margin is 25% of the non-current assets of
RM 500 million;
-
A RM 0.20 investment in additional non-current assets for every RM 1 increase in
sales revenue;
-
RM 80 million additional investments in other small projects.
In addition to the above sales revenue and profits, Siri Bhd has one overseas subsidiary TTY Co, from which it receives dividends of 80% on profits. TTY Co produces a specialist tool which it sells locally for $ 60 each. It is expected that it will produce and sell 4,000,000 units of this specialist tool next year. Each tool will incur variable costs of $ 36 per unit and total annual fixed costs of $ 40 million to produce and sell.
Siri Bhd pays corporation tax at 25% and TTY Co pays corporation tax at 20%. In addition to this, a withholding tax of 8% is deducted from any dividends remitted from TTY Co. A bi-lateral tax treaty exists between the countries where Siri Bhd is based and where TTY Co is based. Therefore corporation tax is payable on profits made by subsidiary companies, but full credit is given for corporation tax already paid. It can be assumed that receipts from TTY Co are in $ equivalent amounts and exchange rate fluctuations on these can be ignored.
2. Sale of equity investment in the USA
It is expected that Siri Co will receive USD 200 million in three months time from the saleof its investment. The $ has continued to remain weak, while the RM has continued to remain strong through 2017 and the start of 2018.
The financial press has also reported that there may be a permanent shift in the RM/$ exchange rate, with firms facing economic exposure. Siri Bhd has decided to hedge the $ receipt using one of currency forward contracts, currency futures contracts or currency options contracts.
3. The following exchange contracts and rates are available to Siri Co.
Per $ 1 Spot rates RM 3.9585 RM 3.9618 Three-month forward rates RM 3.8559RM 3.8601
Currency futures (contract size $125,000, quotation: RM per $1)
March futures RM 3.8538 June futures RM 3.8552
Currency options (contract size $125,000, exercise price quotation RM per $1, premium per $1)
Calls Puts
Exercise price March June. March. June.
3.8500 0.0188 0.0135 0.0124 0.0148
It can be assumed that futures and options contracts expire at the end of their respective months.
4. Dividend history, expected dividends and cost of capital, Siri Bhd
Year to end of February. 2013. 2014. 2015. 2016
Number of RM 1 equity shares in issue (000) 600,000. 60,000. 800,000. 800,000
Total dividends paid ($ 000). 128,320. 136,020. 192,240. 203,770
It is expected that dividends will grow at the historic rate, if the large project is not undertaken. Expected dividends and dividend growth rates if the large project is undertaken
-
Year to end of February 2019: Remaining cash flows after the investment in the
RM 400 million projects will be paid as dividends.
-
Year to end of February 2020: The dividends paid will be the same amount as the
previous year.
-
Year to end of February 2021: Dividends paid will be RM 0.31 per share.
-
In future years from February 2021: Dividends will grow at an annual rate of 7%.
Siri Bhds cost of equity capital is estimated to be 12%.
Required:
a) With reference to purchasing power parity, explain how exchange rate fluctuations may lead to economic exposure.
b) Prepare a discussion paper, including all relevant calculations, for the board of
directors (BoD) of Siri Bhd which:
i. Estimates Siri Bhds dividend capacity as at 28 February 2018, prior to investing in the large project;
ii. Advises Siri Bhd on, and recommends, an appropriate hedging strategy for the USD receipt it is due to receive in three months time from the sale of the equity
investment;
iii. Using the information on dividends provided in the question, and from (b) (i) and (b) (ii) above, assesses whether or not the project would add value to Siri
Bhd;
iv. Discusses the issues of proposed methods of financing the project which need to be considered further.
Assessment Questions 2 - Case Analysis Siri Bhd. is an engineering company which is involved in projects around the world. It has been growing steadily for several years and has maintained a stable dividend growth policy for a number of years now. The board of directors (BOD) is considering bidding for a large project which requires a substantial investment of RM 400 million. It can be assumed that the date today is 1 March 2018. The BoD is proposing that Siri Bhd. should not raise the finance for the project through additional debt or equity. Instead, it proposes that the required finance is obtained from a combination of funds received from the sale of its equity investment in a USA company and from cash flows generated from its normal business activity in the coming two years. As a result, Siri Bhd's current capital structure of 800 million RM 1 cquity shares and RM 700 million 5% bonds is not expected to change in the foreseeable future. The BoD has asked the company's treasury department to prepare a discussion paper on the implications of this proposal. The following information on Siri Bhd. has been provided to assist in the preparation of the discussion paper. undertaking the large project for 1. Expected income and cash flow commitments prior the year to the end of February 2018 8 MAHSA UNIVERSITY i. Siri Bhd's sales revenue is forecast to grow by 8% next year from its current level of RM 3 billion, and the operating profit margin on this is expected to be 15%. It is expected that Siri Bhd will have the following capital investment requirements for the coming year, before the impact of the large project is considered: A RM 0.10 investment in working capital for every RM 1 increase in sales revenue; ii. An investment equivalent to the amount of depreciation to keep its non-current asset base at the present productive capacity. The current depreciation charge already included in the operating profit margin is 25% of the non-current assets of RM 500 million; A RM 0.20 investment in additional non-current assets for every RM 1 increase in sales revenue; RM 80 million additional investments in other small projects. iv In addition to the above sales revenue and profits, Siri Bhd has one overseas subsidiary - TTY Co, from which it receives dividends of 80% on profits. TTY Co produces a specialist tool which it sells locally for $ 60 each. It is expected that it will produce and sell 4,000,000 units of this specialist tool next year. Each tool will incur variable costs of S 36 per unit and total annual fixed costs of $ 40 million to produce and sell. Siri Bhd pays corporation tax at 25% and TTY Co pays corporation tax at 20%. In addition to this, a withholding tax of 8% is deducted from any dividends remitted from TTY CO. A bi-lateral tax treaty exists between the countries where Siri Bhd is based and where TTY Co is based. Therefore corporation tax is payable on profits made by subsidiary companies, but full credit is given for corporation tax already paid. It can be assumed that receipts from TTY Co are in $ equivalent amounts and exchange rate fluctuations on these can be ignored. 2. Sale of equity investment in the USA It is expected that Siri Co will receive USD 200 million in three months' time from the sale of its investment. The S has continued to remain weak, while the RM has continued to remain strong through 2017 and the start of 2018 9 MAHSA UNIVERSITY The financial press has also reported that there may be a permanent shift in the RM/$ exchange rate, with firms facing economic exposure. Siri Bhd has decided to hedge the receipt using one of currency forward contracts, currency futures contracts or currency options contracts. 3. The following exchange contracts and rates are available to Siri Co. Per $1 RM 3.9585 RM 3.9618 Spot rates Three-month forward rates RM 3.8559-RM 3.8601 Currency futures (contract size $125,000, quotation: RM per SI) March futures RM 3.8538 June futures RM3.8552 Currency options (contract size $125,000, exercise price quotation RM per $1, premium per S1) Calls Puts Exercise price March June March June 3.8500 0.0188 0.0135 0.0124 0.0148 It can be assumed that futures and options contracts expire at the end of their respective months 4. Dividend history, expected dividends and cost of capital, Siri Bhd Year to end of February 2013 2014 2015 2016 Number of RM 1 equity shares in issue 600,000 60.000 800,000 800,000 (000) Total dividends paid ($ 000) 128,320 136,020 192,240 203,770 10 MATIKA MAHSA UNIVERSITY It is expected that dividends will grow at the historic rate, if the large project is not undertaken. Expected dividends and dividend growth rates if the large project is undertaken Year to end of February 2019: Remaining cash flows after the investment in the RM 400 million projects will be paid as dividends. Year to end of February 2020: The dividends paid will be the same amount as the previous year. Year to end of February 2021: Dividends paid will be RM 0.31 per share. In future years from February 2021: Dividends will grow at an annual rate of 7%. . . Siri Bhd's cost of equity capital is estimated to be 12%. Required: a) With reference to purchasing power parity, explain how exchange rate fluctuations may lead to economic exposure. (10 marks) b) Prepare a discussion paper, including all relevant calculations, for the board of directors (BOD) of Siri Bhd which: i. Estimates Siri Bhd's dividend capacity as at 28 February 2018, prior to investing in the large project; (9 marks) ii. Advises Siri Bhd on, and recommends, an appropriate hedging strategy for the USD receipt it is due to receive in three months' time from the sale of the equity investment; (14 marks) Assessment Questions 2 - Case Analysis Siri Bhd. is an engineering company which is involved in projects around the world. It has been growing steadily for several years and has maintained a stable dividend growth policy for a number of years now. The board of directors (BOD) is considering bidding for a large project which requires a substantial investment of RM 400 million. It can be assumed that the date today is 1 March 2018. The BoD is proposing that Siri Bhd. should not raise the finance for the project through additional debt or equity. Instead, it proposes that the required finance is obtained from a combination of funds received from the sale of its equity investment in a USA company and from cash flows generated from its normal business activity in the coming two years. As a result, Siri Bhd's current capital structure of 800 million RM 1 cquity shares and RM 700 million 5% bonds is not expected to change in the foreseeable future. The BoD has asked the company's treasury department to prepare a discussion paper on the implications of this proposal. The following information on Siri Bhd. has been provided to assist in the preparation of the discussion paper. undertaking the large project for 1. Expected income and cash flow commitments prior the year to the end of February 2018 8 MAHSA UNIVERSITY i. Siri Bhd's sales revenue is forecast to grow by 8% next year from its current level of RM 3 billion, and the operating profit margin on this is expected to be 15%. It is expected that Siri Bhd will have the following capital investment requirements for the coming year, before the impact of the large project is considered: A RM 0.10 investment in working capital for every RM 1 increase in sales revenue; ii. An investment equivalent to the amount of depreciation to keep its non-current asset base at the present productive capacity. The current depreciation charge already included in the operating profit margin is 25% of the non-current assets of RM 500 million; A RM 0.20 investment in additional non-current assets for every RM 1 increase in sales revenue; RM 80 million additional investments in other small projects. iv In addition to the above sales revenue and profits, Siri Bhd has one overseas subsidiary - TTY Co, from which it receives dividends of 80% on profits. TTY Co produces a specialist tool which it sells locally for $ 60 each. It is expected that it will produce and sell 4,000,000 units of this specialist tool next year. Each tool will incur variable costs of S 36 per unit and total annual fixed costs of $ 40 million to produce and sell. Siri Bhd pays corporation tax at 25% and TTY Co pays corporation tax at 20%. In addition to this, a withholding tax of 8% is deducted from any dividends remitted from TTY CO. A bi-lateral tax treaty exists between the countries where Siri Bhd is based and where TTY Co is based. Therefore corporation tax is payable on profits made by subsidiary companies, but full credit is given for corporation tax already paid. It can be assumed that receipts from TTY Co are in $ equivalent amounts and exchange rate fluctuations on these can be ignored. 2. Sale of equity investment in the USA It is expected that Siri Co will receive USD 200 million in three months' time from the sale of its investment. The S has continued to remain weak, while the RM has continued to remain strong through 2017 and the start of 2018 9 MAHSA UNIVERSITY The financial press has also reported that there may be a permanent shift in the RM/$ exchange rate, with firms facing economic exposure. Siri Bhd has decided to hedge the receipt using one of currency forward contracts, currency futures contracts or currency options contracts. 3. The following exchange contracts and rates are available to Siri Co. Per $1 RM 3.9585 RM 3.9618 Spot rates Three-month forward rates RM 3.8559-RM 3.8601 Currency futures (contract size $125,000, quotation: RM per SI) March futures RM 3.8538 June futures RM3.8552 Currency options (contract size $125,000, exercise price quotation RM per $1, premium per S1) Calls Puts Exercise price March June March June 3.8500 0.0188 0.0135 0.0124 0.0148 It can be assumed that futures and options contracts expire at the end of their respective months 4. Dividend history, expected dividends and cost of capital, Siri Bhd Year to end of February 2013 2014 2015 2016 Number of RM 1 equity shares in issue 600,000 60.000 800,000 800,000 (000) Total dividends paid ($ 000) 128,320 136,020 192,240 203,770 10 MATIKA MAHSA UNIVERSITY It is expected that dividends will grow at the historic rate, if the large project is not undertaken. Expected dividends and dividend growth rates if the large project is undertaken Year to end of February 2019: Remaining cash flows after the investment in the RM 400 million projects will be paid as dividends. Year to end of February 2020: The dividends paid will be the same amount as the previous year. Year to end of February 2021: Dividends paid will be RM 0.31 per share. In future years from February 2021: Dividends will grow at an annual rate of 7%. . . Siri Bhd's cost of equity capital is estimated to be 12%. Required: a) With reference to purchasing power parity, explain how exchange rate fluctuations may lead to economic exposure. (10 marks) b) Prepare a discussion paper, including all relevant calculations, for the board of directors (BOD) of Siri Bhd which: i. Estimates Siri Bhd's dividend capacity as at 28 February 2018, prior to investing in the large project; (9 marks) ii. Advises Siri Bhd on, and recommends, an appropriate hedging strategy for the USD receipt it is due to receive in three months' time from the sale of the equity investment; (14 marks)
