RCA Limited was a diversified brand management, marketing and manufacturing company operating in Australia, New Zealand and Asia. Its portfolio included cleaning products, household appliances, storage solutions, automotive products, water products and security products.

RCA’s primary objective was to produce long-term shareholder returns above the cost of capital and to maximise the value of its brand portfolio for the benefit of shareholders. Growth would be pursued through internal product and technology developments, new business streams and complimentary acquisitions. Debt was minimised through firm control over capital employed, providing the flexibility to undertake acquisitions as opportunities arose.

The effects of the major business repositioning programs, coupled with new product initiatives, were evident in the five-year financial summary and ratios below, which excluded individually significant items:

For the year ending 31 December 2015 2014 2013 2012 2011

Sales revenue ($ millions) 394.3 393.7 372.5 365.8 341.1

Net trading profit after tax ($ millions) 37.8 41.7 27.4 20.8 11.6

Free cash flow ($ millions) 25.7 34.0 42.7 67.8 7.9

Net debt ($ millions) 37.6 17.5 20.8 38.1 73.1

Total equity ($ millions) 135.8 142.5 126.8 121.7 130.8

Return on equity 27.7% 29.3% 21.6% 17.1% 8.9%

Earnings per share (cents) 63.0 68.6 45.3 33.7 17.9

Dividends per share (cents) 50.0 40.0 26.0 16.5 15.0

In the year ending 31 December 2015, Cash Value Added (CVA) return decreased to 18.1 percent from 21.2 percent but all business divisions exceeded RCA’s weighted average cost of capital benchmark. CVA was RCA’s principal measure of business unit and group performance and was defined as cash profit after tax divided by total capital employed at cost. Net debt remained low at 8.4 percent of market capitalisation and the interest cover was a healthy 16.4 times.

The Board was comprised of four Non-Executive Directors and the Managing Director, Mark Bingo. Meetings were generally held monthly with ad hoc meeting called to consider specific or urgent matters. Senior executives regularly attended and presented to board meetings on particular issues. The following agenda items were discussed at the last board meeting:
What would be RCA’s company after-tax WACC based on its capital structure as at 31/12/15?
Should a different cost of capital be established for each business division? How should each divisional cost of capital be measured?

iii. Further, how should the risk of each project within a division be measured and incorporated into project evaluation?

Should the two new cleaning products proposals be approved and how to finance them?
Should RCA continue its share buy-back program?
Should RCA change its dividend payout?

RCA had established a capital allocation policy that required NPV to be used in all investment decisions. The after-tax WACC for the company would be calculated annually using the market value of the gross interest–bearing debt and equity securities outstanding at the balance date. Bingo reported that the company WACC was about 9 percent at the end of December 2015.
RCA’s Balance Sheet as at 31 December 2015 showed the following data:

($’000) ($’000)

Payables 32800 Cash 23300

Current tax liabilities 3800 Receivables 50000

Bank overdraft 3400 Inventories 67200

Bank loan 57500 Property, plant and equipment 27200

Provisions 11800 Intangibles 61600

Share capital 98400 Other 15700

Reserves 1400

Retained profits 35900

Total claims 245000 Total assets 245000

The equity beta of RCA’s 60 million outstanding ordinary shares was estimated to be 1.18 and shares were traded on the ASX at $7.50. New shares could be placed with institutional investors at about $7.20. The risk-free rate was assumed to be 2.6%. RCA used a market risk premium of 6% in all cost of equity estimates. The company tax rate was 30%.

RCA had arranged an unsecured bank overdraft with a limit of $7 million and $3.4 million had been used at balance date. Interest on bank overdrafts was charged at prevailing market rates. The current interest rate on overdrafts was 8.70%. RCA also had a $100 million unsecured bank loan facility with about $42.5 million still not utilised. The outstanding bank loan of $57.5 million had 3 years to maturity and was charged at the interest rate of 8.40% on a reducing balance basis. The interest rate on a new 3-year bank loan would be 7.40%.

The Board decided that a separate cost of capital should be established for its business divisions. The divisional WACC would be based on the respective industry weighted average cost of capital. New projects evaluated by each division would be classified into three categories: high risk, average risk and low risk. High risk projects would be evaluated at the yet-to-be-determined divisional WACC plus 2%; average projects at the divisional WACC; and low risk projects at the divisional WACC minus 1.5%.

The General Manager of Cleaning Products Division, Tim Brealey, questioned the use of industry weighted average cost of capital. Brealey pointed that a typical cleaning products firm would have a higher debt-equity ratio at 60% and a higher cost of debt.

Two new project proposals were presented by Brealey at the meeting. Both projects would be managed by the Cleaning Products Division. The first proposal, MAT101, was to manufacture a range of premium mats for entryways. These mats would be durable, skid resistant and caused minimal movement on hard surfaces.

The second proposal was to acquire Best Klean business, a leading brand commercial cleaning products distributor, for $25 million. A $100,000 preliminary study completed recently endorsed the proposal. If the performance in the first two years exceeded expectations, RCA would consider expanding the business to household segments. On the other hand, the business might be sold off in two years’ time if the performance was below expectations. The project would run as a going concern without expansion or abandonment if expectations were met. The preliminary study identified the probabilities for the performance to exceed, in line with and below expectations to be 30%, 60% and 10% respectively.

The Board asked Bingo to re-examine the financial details of both projects and make a recommendation about their viability as well as their funding method.
To establish the weighted average cost of capital for the Cleaning Products Division, Bingo used an industry equity beta of 1.10 to estimate the industry cost of equity. Combining it with an industry debt-equity ratio of 0.6 and an industry cost of debt of 9.6%, Bingo was able to work out the cleaning products industry WACC and used it as the divisional WACC.

Bingo discovered that the NPV in Table 1 and Table 2 used a notional cost of capital of 10%, rather than an appropriate project cost of capital. MAT101 was classified as high risk while the acquisition of Best Klean was considered to be average risk. The expansion option of Best Klean was regarded to be low-risk.

On the project Best Klean, the cash flows referred to in the ‘Expansion’ option (Table 2) were the additional after-tax cash flows generated over and above the cash flows expected from the existing business of Best Klean as shown in Table 3. However the construction of cash flows in Table 3 was incomplete.

RCA used a 5-year valuation horizon. Bingo noted that the after-tax cash flow of year 5 in Table 1 and Table 2 had already included a terminal value. However the terminal value was not included in Table 3 and would need to be estimated separately using a terminal growth rate of 3%.

RCA began an on-market share buy-back program in September 2010. Since commencement, 8.1 million shares had been bought and dividends totalling $9.7 million had been saved as a result. In 2015, RCA bought back and cancelled 1 million shares at an average price of $8.00. The number of shares on issue was reduced to 60 million. The share buy-back program was regarded to be highly effective as it was earnings per share positive. The Board decided to continue the buy-back program until December 2016 amid volatile share price.

The dividend reinvestment plan was suspended in 2014. Bingo suggested that a DRP with a 2.5% discount was a relatively cheap way to issue new equity. RCA used to attract a 30 percent participation rate from its shareholders before the plan was suspended. A reintroduction of the DRP would allow RCA to raise payout substantially.

The Board believed that RCA had plenty of scope to maintain a positive trend for dividends as the payout ratio was not demanding. RCA did not have a formal dividend policy but its simple objective was to increase dividends each year with the growth of sustainable earnings. For 2015 financial year, the payout ratio was increased to 79 percent, still below peers. The Board intended to lift the dividend payout to 56 cents in 2016. The company guidance for net profit after tax in 2016, without any new acquisitions, was to be $41.6 million.

Despite higher dividends and share buy-backs, net debt to market capitalisation remained at below 10 percent on current share price of $7.50. RCA normally used net debt to measure its gearing level. The ratio of gross debt to total assets was 25%, below those of the competitors. Substantial borrowing capacity existed for new acquisition opportunities.

Table 1

After-tax cash flow projections for ‘MAT101’ ($’000)

Year Cash flow Discounted value @10%

t=0 -2000 -2000

t=1 200 182

t=2 350 289

t=3 450 338

t=4 500 342

t=5 2500 1552

NPVt=0 = 703
Table 2

After-tax cash flow projections for ‘Expansion’ option of Best Klean ($’000)

Year Expansion Discounted value @10%

t=0 0 0

t=1 0 0

t=2 -1400 -1400

t=3 300 273

t=4 500 413

t=5 3000 2254

NPVt=2 = 1540

Table 3
Free Cash Flow estimate for Best Klean existing business ($’000)
t=1 t=2 … t=5 t=6
Revenue 4000
Variable cost 1600
Fixed cost 300
Depreciation 200
Operating income 1900
Tax (30%) 570
Net income 1330
Depreciation 200
Operating cash flow 1530
Investment in fixed assets 150
Investment in working capital 100
Free cash flow 1280
All figures are rounded to the nearest thousand dollars.
Assumptions:
Maximum revenue capacity without expansion
$5 million
Tax rate
30%
Revenue growth rate in year 2
10%
Revenue growth rate in year 3
6%
Revenue growth rate in year 4
4%
Revenue growth rate from year 5 onwards
3%
Variable cost as a percentage of sales in years 1-6
40%
Fixed cost growth rate 5% per year
Depreciation in years 1-6 Constant $200,000 per year
Investment in fixed assets in years 1-6 Constant $150,000 per year
Investment in working capital in years 2–6 is equal to 20% of the change in revenue from the previous year.

Instructions:

Attempt the following problems to help Bingo make the decisions. All cash flow and present value figures must be rounded to the nearest thousand dollars. Show all workings and/or explanation.

Calculate RCA’s company after-tax WACC, rounded to four decimal places.
Calculate the Cleaning Products Division WACC, rounded to four decimal places.
What could be deduced about the relative business risk of the Cleaning Products Division compared to other cleaning products firms when the industry equity beta was used to estimate the divisional cost of equity?
Calculate the NPVt=0 of project MAT101 using the appropriate discount rate.
Calculate the NPVt=2, at the end of year 2, for the expansion option of Best Klean.
Complete Table 3 fully, in accordance with the given assumptions, to show how the free cash flow in years 1-6 is derived.
For Best Klean existing business, calculate the terminal value as of year 5 using the constant-growth discounted cash flow formula.
Calculate the present value, as of year 0, of Best Klean existing business? [Show individually the discounted value, as of year 0, of the free cash flow in years 1-5 plus that of the terminal value.]
Calculate the value of the option for Best Klean to expand as at year 0.
If Best Klean could be sold off for $30 million at the end of year 2, calculate the value of the abandonment option as at year 0.
What is the present value of Best Klean with expansion and abandonment all considered?
Given RCA’s financial position at 31/12/2015, how would RCA finance the two projects? Name the specific source(s) of finance.
In 2015, dividend was increased to 50 cents per share despite a fall in the net trading profit after tax and EPS. Apart from a possible signal of higher future earnings, explain the real reason behind the dividend increase.
Given the free cash flow and the dividend payout in 2015, how could RCA afford to repurchase 1 million shares during the financial year 2015. Support your argument with numbers.
If the financial results for the year ending 31 December 2015 were to be repeated in future years, should RCA continue to repurchase its shares? Explain and support your argument.
If the DRP was to be reinstated, would a 2.5% price discount be too high? Support your decision with calculations.

Group limit: Students can form a group of 4 people or less to attempt the assignment. [UTSOnline Discussion Board may help students find partners.] If a student is unable or unwilling to find anyone else to form a group, he/she has to attempt the case study individually.

Presentation: The assignment is to be typed, doubled spaced with a font size of 12 (no smaller than this font size). The length of the submitted work should not exceed 7 A4 pages including the cover page and any spreadsheet.

Answer each question in correct sequence. Do not separate any table/spreadsheet from the body of the answers. No appendices should be used.

Do not use more than 50 words to explain the answer in any question. No mark will be awarded in any question if exceeding the word limit.

Due Date: The assignment is to be submitted to the assignment box ‘FINANCE 5’ at Building 8 Level 5 before Friday 3 June 2pm. The assignment is worth 20 marks. Each question is worth one mark except questions 1, 2 and 6.

Late submission, with whatever excuses, will result in loss of 5 marks per 24 hours or thereof. Students are expected to have completed Questions 1-11 by mid-May.

Members of a group will receive the same mark for the assignment. Get started early to avoid problems such as team members getting sick or leaving the group unexpectedly. As in real life, students have to deal with the “free-rider” problem themselves and be actively involved to avoid being kicked out of a group.

Assessment: Most issues involved in the case would have been covered in classes. Team discussion of all questions helps achieve a better result (half of the individual work submission received a fail grade in spring semester 2015).

The following will be considered in assessing the submitted work:

– the correctness of the calculations and reasoning; no partial credit is given in any 1-mark question

– the 50-word limit on explanation

– the quality of the written expression (grammar, spelling etc…)

– plagiarism will result in zero marks for the assignment (all assignments are marked by the subject coordinator himself)

Note:

No plastic cover. Just staple the 7 pages together.
Use the cover sheet provided at UTSOnline and list alphabetically the name of the students with student number included.

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Posted on May 22, 2016Author TutorCategories Question, Questions