Capital Budgeting Case of Cooper Technologies Ltd
Cooper Technologies Ltd is a company that provides geospatial services for national governments, states, provinces, counties, municipalities, and commercial organisations around the world. The company’s geospatial services encompass the acquisition, analysis, integration, visualisation and management of geospatial data. To boost their competitive advantage against peer firms in the area of geospatial data acquisition, Cooper Technologies Ltd has decided to launch a new Earth observation satellite. After carefully considering sale proposals from a number of well-known aerospace companies, Cooper Technologies Ltd has narrowed their choice to two next-generation imaging satellites: RD-6 manufactured by Davis Group Ltd and MK-8 by Koshiba Aerospace Ltd. Both satellites are regarded as suitable to complete the required job. As the financial comptroller of Cooper Technologies Ltd, you have been requested by the management board to advise which one of the two satellites the company should purchase.
The cost of a single RD-6 satellite is $350 million. A MK-8 imaging satellite carries a price tag of $300 million. Another significant factor with satellites is the cost of the launch. In particular, launching a single RD-6 satellite into space is expected to cost the company $100 million. Due to its heavier weight, launching a MK-8 satellite warrants a heavy-lift launch vehicle instead of a medium-lift launch vehicle used in the case of a RD-6 satellite launch. As a result, the cost of a MK-8 satellite launch is estimated to be $185 million. Both satellites are to be depreciated straight line down to a book value of zero over their entire useful life. Further details of each satellite’s cash flows are tabulated below:
RD-6 satellite MK-8 satellite
Annual revenue (to be received at the end of the year) $105 million $100 million
Annual operating cost (to be paid at the end of the year) $25 million $21 million
Satellite life 15 years 20 years
In addition to the cash flow information, you have also been provided with the following details:
• The corporate tax rate is 30%;
• Tax is paid on profits at the end of the year in which it is earned;
• Both investment opportunities are considered as risky as the company;
• Cooper Technologies Ltd currently has a beta of 1.2;
• The risk-free rate is 5% p.a.; and,
• The expected return on the market is 9% p.a.
Question 1 (2 marks)
Calculate the required rate of return for each investment opportunity.
Question 2 (5 marks)
Calculate the net present value (NPV) for RD-6 satellite.
Question 3 (5 marks)
Calculate the NPV for MK-8 satellite.
Question 4 (7 marks)
Based on the equivalent annual cash flow, which satellite, if any, do you recommend Cooper Technologies Ltd to proceed with ?
Question 5 (4 marks)
a. Calculate the internal rate of return (IRR) for each satellite. (2 marks)
b. Based on your IRR calculations, identify which, if any, of the satellites you would recommend that Cooper Technologies Ltd purchase:
- If the projects are independent (1 mark)
- If the projects are mutually exclusive (1 mark)
Question 6 (7 marks)
a. Calculate the payback period and discounted payback period for RD-6 satellite. (2 marks)
b. Calculate the payback period and discounted payback period for MK-8 satellite. (2 marks)
c. Identify which satellite the company would invest based on the discounted payback period, assuming the projects are mutually exclusive. (1 mark)
d. Discuss one limitation that both payback period and discounted payback period have in common. (1 mark)
e. Discuss one advantage of discounted payback period over payback period. (1 mark)
Question 7 (8 marks)
Assuming that Cooper Technologies Ltd has successfully negotiated with the tax office to pay tax in arrears (i.e., tax is paid on profits one years after it is earned),
a. Re-calculate the NPV for RD-6 satellite. (4 marks)
b. Re-calculate the NPV for MK-8 satellite. (4 marks)
Question 8 (6 marks)
To prepare funding for the investment project, Cooper Technologies Ltd issued 15-year bonds to the public exactly three months ago. These bonds would pay semi-annual coupons at a rate of 11% p.a.. The rate of return required by investors on these instruments has been estimated at 10% p.a.. Each bond has a face value of $100,000.
a. Calculate today’s price of each bond. (3 marks)
b. Consider the current term structure as follows: corporate bonds with maturity from 1 years to 5 years yield 8% p.a., corporate bonds with maturity from 6 years to 9 years yield 9% p.a., and 10-year bonds and longer-maturity bond yield 12% p.a.. Recalculate today’s price of each bond. (3 marks)
Question 9 (6 marks)
To further increase funding for the investment project, Cooper Technologies Ltd has decided to withdraw dividend payments for the next two years (i.e., year 1 and year 2). Thereafter, the company expects to maintain a payout ratio of 60% for five years (i.e., year 3 to year 7). Afterward, the company expects to increase the payout ratio to 80% and maintain it forever. The company’s return on equity (ROE) is 21%.
a. Calculate the annual dividend growth rate from year 3 to year 7. (1 mark)
b. Calculate the annual dividend growth rate from year 7 onward. (1 mark)
c. Given that the dividend per share in year 3 is $2, calculate the price of each share in today’s dollar (i.e., share price in year 0). (4 marks)