You are the CFO of Aust Defence Supplies Inc – a mature publicly listed Australian firm supplying low technology products for use in the defence forces, and to the camping and hiking leisure market. The business has several divisions based around Brisbane, with their head offices in South Brisbane.
The last annual report and market data provides the following information regarding the financial structure of the company. The liabilities of Aust Defence Supplies include:
- 1,000 unsecured notes on issue, and a $100-dollar coupon payment ($50 paid semi-annually). The notes mature in 11 years, and the current trading price on the note is $980; the face value is $1,000.
- 900 debentures which mature in 8 years and have a current market price of $1,115. The debentures have a face value of $1,000 and pay a coupon payment of $112 annually.
- 2,500 issued shares of preferred stock, with current market price of $94.50 and paying a dividend of $12.10
- 70,000 ordinary shares with a current market price is $44. The company has picked up some contracts over the last few years, with growth in earnings, averaging 8.2 per cent per year. It is expected with current opportunities that this might continue for two more years, but then slow to 3 or 4%. The company directors have just declared a dividend of $4.34 per share for the last 12 months.
The Reserve Bank has suggested that inflation rates are expected to be stable at about 2%. The company tax rate faced by Aust Defence Supplies is 27.5%.
What is the cost of capital of Aust Capital Supplies?
You have received a confidential envelope. It contains a draft of a competitive bid notification for a contract to supply duffel canvas to the Australian Navy. The cover memo from Aust Defence Supplies’ CEO David Sharpe asks you to review the bid before it is submitted.
The bid and its supporting documents have been prepared by Aust Defence Supplies’ sales staff. It calls for Aust Defence Supplies to supply 100,000 metres of duffel canvas per year for 5 years. The proposed selling price is fixed at $30 per metres.
You are not usually involved in sales, but this bid was unusual in a few ways. First, if accepted by the navy, it would commit Aust Defence Supplies to a fixed-price, long-term contract. Second, producing the duffel canvas would require an investment of $1.5 million to purchase machinery and to refurbish Aust Defence Supplies’ small building/plant at the Port of Brisbane. You have also collected over the last week the following facts:
- The plant at the Port of Brisbane had been built in the mid 1900s and is now idle, as the company had refocussed on providing higher value add products. The plant is fully
depreciated on Aust Defence Supplies’ books, except for the purchase cost of the land (in 1962) of $30,000.
- Recognising that the land was valuable shorefront property, you think the land and the idle plant could be sold, immediately or in the near future, for $800,000.
- Refurbishing the plant would cost $500,000. It would be expensed with a depreciation life of 10 years.
- The new machinery would cost $1 million.
- The refurbished plant and new machinery would last for many years. However, the remaining market for duffel canvas is small, and it was not clear that additional orders could be obtained once the navy contract is finished. The machinery will be custom-built and can be used only for duffel canvas. Its second-hand value at the end of 5 years is probably zero.
- Mr Sharpe thought that working capital would average about 10 percent of sales.
- Metres sold and price per metre would be fixed by the duration of the contract.
- Cost of goods includes fixed cost of $300,000 per year plus variable costs of $18 per metre. Costs are expected to increase at the inflation rate.
- Depreciation: A $1 million investment in machinery is depreciable straight-line over 5 years ($200,000 per year). The $500,000 cost of refurbishing the Port of Brisbane plant is depreciable straight-line over 10 years.
A second envelope has also arrived from the company’s Business Development Manager (Liping Xiao). It contains what Ms Xiao described as a firm offer from a real estate developer to purchase the Port of Brisbane land and plant for $1.5 million in cash – but you have noticed that the offer was subject to Council approval for development of the land as waterfront (or close to) apartments.
Should you recommend submitting the bid for this competitive tender to the Navy at the proposed price of $30 per metre, or make a counter offer? Comment on critical issues to be considered, including the offer from the real estate developer. Given the nature of the sales contract with the Navy, the sales aspect is low risk and therefore it is considered that the discount rate could be 2% below the company cost of capital.
The company has an existing operation making portable utensils and products for mobile use and currently uses an injection moulding machine that was purchased two years ago. This machine is being depreciated on straight line basis over eight years; it has six years of remaining life, and its current book value is $430,000. The machine currently could be sold for $46,000. A replacement machine can be purchased that has a cost of $1,200,000, an estimated useful life of six years, and an estimated salvage value of $150,000. This machine can be depreciated for tax purposes over a five- year straight-line schedule. The division manager expects, but is not strongly certain that the replacement machine would permit an output expansion of 11,500 units in the first year, 12,500 units in the second year and 14,000 thereafter – from the current output of 111,080 units – and you can sell all you make at the current price of $21 per unit. Even so, one of the big advantages of the machine is its greater operating efficiency. Again, without great certainty, the managing director expects to save $2.25 per unit in current dollars off the current operating costs over the longer term, but in the first year the saving would only be $1.50 per unit (while the workers learn to use the machine). The new machine would require inventories to be increased by $300,000, but accounts payable would simultaneously increase by $100,000.
As you are the CFO, you are required to determine whether the company should undertake the replacement? Given the uncertainty you are also required to provide insight into how the uncertain factors impact on your recommendation.