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MP124-Corporate Finance

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Question:

1. Auscann Group Holdings Ltd (hereafter known as “Auscann”) ordinary shares are listed on the Australian Securities Exchange following the company’s Initial Public Offering (“IPO”) in 2012. It is a Perth-based company with the aim of producing and providing quality, economical and clinically validated cannabis medicines. On April 4, 2017 Auscann announced a diversification strategy and plan on acquiring Magic Mushrooms Tours (“Magic”), is a tourism operator in Cairns offering day trips to the Great Barrier Reef. Upon settlement of the transaction MAGIC will then become a wholly-owned subsidiary of Auscann. Auscann already has plans for generating substantially higher returns from its Magic business and one of its first strategies is to purchase a smaller, faster passenger vessel, internally named the Reef Magic 4. Of course, before they purchase the vessel, a rigorous financial analysis is needed to confirm if the vessel will contribute to increasing the wealth of Auscann shareholders.
 
2. You are employed in Auscann’s finance department and have impressed senior management with your aptitude for financial analysis. This talent was developed through the practiceoriented assignments that you completed at WIN. The Chief Financial Officer (“CFO”) has asked you to perform a financial analysis of the planned purchase of the Reef Magic 4 using a purposebuilt preformatted EXCEL spreadsheet. The CFO has suggested you liaise with Auscann employees from a variety of different departments to collect the information that is necessary to perform the analysis. You will also search through public documents to identify some of the assumptions that will be required in your financial analysis, and to locate the data required to analyse Auscann’s 2016 equity capital raising. Your analysis will be provided to the Board of Directors who must approve substantial capital expenditures. The directors are accountable to the shareholders and so a rigorous due diligence is necessary to be confident that the investment in the Reef Magic 4 is justified. The following paragraphs contain a substantial amount of information that has been gathered and it is your job to determine which information is relevant to the financial analysis.
 
3. In January 2017 Auscann commissioned Tourism Australia to analyse prospects for the Cairns tourism industry. The report cost $175,000 and was paid in full in March 2017. The forecasts indicate a large, and growing, potential market in the Cairns precinct due to the revitalised convention centre, an abundance of natural and unique treasures, and growing numbers of international flights between Cairns and nearby south-east Asian cities. These factors encourage the Board of Directors that the decision to purchase the Reef Magic 4 is the right decision but you caution that it must first pass an objective cost-benefit assessment.
 
4. The capital cost of the Reef Magic 4 in 2017 is exactly the same as the cost of the Reef Magic 2 as reported in the Announcement. According to the Australian Taxation Office (“ATO”) the Reef Magic 4 is classified as a non-current asset and has an estimated useful life of eight years. However, Auscann will operate the Reef Magic 4 for ten years only, at which time it will be sold. Auscann has a policy of depreciating all non-current assets to zero over a twenty-year period for internal management reporting purposes.
 
5. To allow sufficient space for the Reef Magic 4 to dock at the Cairns Reef Fleet Terminal Auscann will need to arrange for additional mooring space. However, Auscann’s due diligence into the Magic acquisition reveals that Magic has berthing rights for a pier that it is currently leasing to an unrelated tourist operator for a fixed $115,000 per annum. If Auscann proceeds with the Reef Magic 4, they will cancel the lease (without any financial penalty) and moor the vessel at the pier. If Auscann do not purchase the Reef Magic 4 they will continue to lease the pier for the foreseeable future. The directors question if the lease is relevant to the analysis because it has previously been classified as lease income.
 
6. In 2015, Auscann contributed $2 million towards a $4 million upgrade of the Cairns Reef Fleet Terminal. Cairns Council contributed the remaining $2 million. Auscann is depreciating their contribution of the upgrade in their financial statements over a twenty-year period, consistent with ATO policy. The assets related to this investment have no value today.
 
7. If Auscann purchase the Reef Magic 4 then they must sell certain slipway assets. The assets had a total capital cost in 2013 of $600,000 and for tax purposes have a ten-year life. The slipway assets have a scrap value today of $130,000. Auscann will use the sale proceeds to distribute a $130,000 dividend to its shareholders today.
 
8. Auscann will implement a private placement to raise $800,000 from sophisticated investors to partly finance the Reef Magic 4. The placement will be managed by Veritas Securities for a fee of 1% of the amount raised. Today, inventory (consisting mostly of spare parts) will need to increase from the current $400,000 to $700,000. Accounts receivable will increase by $750,000 to $3.6 million, and accounts payables would remain at $1,880,000.
 
9. Conservative forecasts are for the Reef Magic 4 to carry 28,000 passengers in the first year of operations (i.e., 2018). Although the stated capacity of the vessel is 150 it operates at below capacity for many days of the year, and is unable to operate at all for prolonged periods during an adverse weather event. Auscann management are confident that the number of passengers will conservatively increase by 1.5% each year for the life of the Reef Magic 4.
 
10. It costs $370,000 a year to operate Auscann’s Perth headquarters. With careful management Auscann believes they will not require any additional personnel in headquarters if they purchase the new ferry. In any case, the annual headquarters operating expense will increase by just 2% each year.
 
11. At the moment, fixed operating costs across the entire Auscann business are $14.5 million per annum. With the purchase of the Reef Magic 4 fixed costs would rise to $17.3 million each year. The annual Magic wages expense based on approximately 100 employees is $7,800,000. Wages directly associated with the purchase of Reef Magic 4 amount to $1,450,000 per year. Reef Magic 4’s annual fuel expense is forecast to be $1,100,000 in the first year. With better vessel management and engine efficiencies, Auscann assumes they can reduce the annual fuel expense by 3% every following year.
 
12. The Reef Magic 4 will require no maintenance in the first three years of its life because it is covered by a manufacturer’s three-year warranty. However, after the warranty expires, the annual repairs and maintenance expense that is needed at the end of each year is assumed to be $870,000. Auscann would still implement the usual repairs and maintenance on the vessel up to and including year ten to maintain resale value.
 
13. The purchase of the new vessel will produce food preparation cost synergies across the existing fleet of Reef Magic vessels resulting from larger purchase quantities and improved negotiating power with suppliers. The annual food preparation expense for the existing vessels is $386,000. Analysis indicates that this figure can be reduced by $46,000 each year with the introduction of the Reef Magic 4. The managing director has studied the preliminary figures that you have collected and enquired if the $386,000 is an opportunity cost.
 
 
14. Auscann has stated (page 6 of the Announcement) its policy is “to maintain [a] prudent capital structure”. Therefore, Auscann will borrow $2 million today to finance the Reef Magic 4. The ten-year interest-only loan has annual repayments of $140,000 (assuming a fixed interest rate of 7% p.a.).
 
15. The Australian Maritime Safety Authority (“AMSA”) requires that passenger ferries possess a valid and current National System Certificate of Survey, Vessel Identifier and Certificate of Operation. These compulsory certifications are required before Auscann can commence operations with the Reef Magic 4. The three certificates cost a total of $200,000 and are valid for ten years. The ATO confirms that all AMSA certificates are operating expenses. To preserve the resale value of the Reef Magic 4 Auscann will recertify the vessel in ten years’ time. Marketing expenses relating to the Reef Magic 4 will be included in Auscann’s existing annual marketing budget of $2,130,000.
 
16. Auscann’s managers suggest that the cost of the $175,000 Tourism Australia report be spread over the ten-year evaluation period. This strategy will ensure the cost earns a fair return and also reduce the impact of a large one-off expense on net profit.
 
17. An analysis of recent vessel transactions suggests that the Reef Magic 4 will have a resale value of $1,800,000 in eight years’ time and $1,300,000 in ten years’ time. You note the ATO regulation that all non-current assets be depreciated to zero. You also have clarified the tax policy that all operating expenses are tax deductible in the year the expense in incurred. 18. The company tax rate is 30% and the required rate of return is 14%.
 
Requirements
 
Your team must answer the following four questions. Enter your answers into the EXCEL spreadsheet. Everyone in your team receives the team’s mark so it your responsibility to ensure each team member makes an equal contribution.
 
Capital Budgeting Information (15 Marks) Present an itemised breakdown (and the total) for each of the following:
 
1. The cash flows at the start.
2. The cash flows over the life.
3. The cash flows at the end.
4. The NPV of the Reef Magic 4 and an explanation of your recommendation.
 
 
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