Corporate Financial Management Assignment

Assignment details

Hypothetical company background

You are an analyst working in the finance department of Candy Crash Limited. Candy Crash is a public listed company that specializes in the production of confectionery. The production relies heavily on the use of machinery. The company has 2,115,000 number of shares outstanding trading on the stock exchange.

Part 1

Candy Crash is currently in negotiation with a large supermarket chain, Costca Limited, to supply its confectionery in a private label for Costca. Under the terms, Candy Crash is expected to supply confectionery to Costca every year for the next ten years.

If Candy Crash proceeds with the supply of confectionery, the company needs to purchase machinery to cope with the increase in production. New machinery is expected to cost $2,800,000, with an additional $500,000 installation and shipping costs. The machinery is expected to have a working life of 10 years. The company's accounting policy is to depreciate using the straight line approach of 10% per year. It is expected that the new machinery can be sold for $200,000 at the end of its useful life.

If Candy Crash is to proceed with the supply of confectionery to Costca, it is expected that the yearly operating revenues would increase by $2,400,000 in year one. From year two onwards, it is expected that the increase in yearly operating revenues would grow at a rate of 5% per annum. Total variable costs associated with the increased production would be 60% of the increase in yearly operating revenues. The fixed costs associated with the increased production are expected to be $300,000 per year. However, as the private label confectionery's selling price is cheaper than Candy Crash's brand, it is expected that Candy Crash's existing operating revenues would fall by $200,000 per annum and existing operating costs would decrease by $80,000 per annum if Candy Crash proceeds with the supply of confectionery. Moreover, there would be an initial increase in net working capital of $50,000. From year one to year nine, net working capital is expected to increase by $10,000 per year. All the net working capitals can be recovered at the end of the project's life.

Given that this project's risk level is not significantly different, you believe that it is appropriate to use the existing WACC of 12.6%. The company's capital structure has remained fairly stable, with a debt-to-equity ratio of 0.8. The company has no plan to adjust its capital structure in the future. The company tax rate is 30%.

Furthermore, the CEO suggests conducting sensitivity analysis as follows because of uncertainty in relation to some of the expected cash flows:

1. Allow for a 30% probability that incremental revenues associated with the supply of private label confectionery would be 40% lower than expected starting from year six;
2. Allow for a 20% probability that incremental revenues associated with the supply of private label confectionery would be 30% higher than expected starting from year six.

Part 2

Semi-strong form efficiency tests are concerned with whether security prices reflect all publicly available information. The event study methodology can be used to investigate the effects of many events such as a corporate announcement. By studying the stock price reaction before, during and after an announcement, an examination of whether the market is semi-strong form efficient can be conducted.

After performing the full analysis in Part 1, Candy Crash decides to proceed with the supply of private label confectionery to Costca (regardless of the NPV and other investment analyses). As such, the company announces details related to the expected increase in profits and net cash flows that it would achieve from the supply of private label confectionery. The table below shows the daily returns of Candy Crash (stock), the market and the risk-free asset 5 days before and after the announcement. Day 0 is the day of the announcement and there is no other price-sensitive announcement within the event window. The company has an equity beta of 1.2.

¹Table 1. Daily returns for Candy Crash, market and risk-free asset during the even window.

Table 1 (2020) courtesy of Dr Mardy Chiah

Required

You are to prepare a report to present to the CEO, based on the Excel analysis you conduct for Part 1 and Part 2.

Part 1

Show the various cash flows based on the different scenarios; assuming that the Candy Crash decides to proceed with the supply of private label confectionery to Costca; taking into consideration of the various scenarios. You should also clearly state any assumptions (if any) made in your analysis. Based on your analysis, is this project a good investment project for Candy Crash?

Part 2

Using Capital Asset Pricing Model (CAPM), calculate the daily abnormal return of Candy Crash during the event window and plot the cumulative daily abnormal returns on a diagram. Daily abnormal return is computed as:

Abnormal return = Actual return Expected return

Discuss the abnormal return pattern of Candy Crash before, during and after the announcement and justify whether the stock price reaction is consistent with semi-strong form market efficiency.

Your response should also include:

1. whether the abnormal return pattern is consistent with the analysis conducted from Part 1; and
2. expectations of what would happen to the share price subsequent to the analysed event window.

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