Managerial Finance STUDY

The Case Study introduces an opportunity to review the learning materials and employ what
have been learnt to the process of making investment, financing and dividend decisions. This
assessment covers all the CLOs of the course, and it is worth 40% of the Final Result.
THE CASE STUDY CONSISTS OF THREE PARTS (PART 1, 2 &3).
You are the Chief Financial Officer (CFO) of Xero Limited (XRO.AX). Recently, XRO is
venturing into the end-to-end encryption-based accounting software and partnering with the
blockchain giant ULTRA. Two companies are working together to develop a blockchain-based
hyperscale data center for the cloud-based encryptions. Building such data center would require
a large investment from XRO. As a result, the development of this new data center will initially
require a capital expenditure equal to 30% of the “total cash” for the fiscal year ended 31
December 2021 (i.e., 𝑡 = 0).
This new data center is expected to have a life of five years. The depreciation is calculated
using the straight-line method. Both the estimated and actual salvage values are assumed to be
zero (i.e., to protect the patient privacy and confidentiality, this data center will be destroyed
at the end of the useful life. Hence, the actual salvage value is zero).
First-year revenue from this data center is expected to be 8% of the “total revenue” for
XRO’s fiscal year ended 31 December 2021. The data center’s revenue is expected to grow at
15% for the second year, then 10% for the third, and 5% annually for the final two years of
the expected life of the project. Your role in this project is to determine the cash flows
associated with this data center. The CEO of XRO has informed you that the profit margin is
similar to the rest of the XRO’s existing projects (i.e., gross profit divided by total revenue).
Section 1: Complete this section using Excel. For calculation purposes, assume we are on 1
January 2022.

1. You are now ready to determine the free cash flow. Compute the free cash flow for each
   year using the financial reports provided for XRO for 2021.
   Set up the computation of the free cash flow in separate, contiguous columns for each year
   of the data center’s life in Excel. Be sure to make outflows negative and inflows positive.
   a. You may assume that the data center’s profitability will be similar to XRO’s existing
   projects in 2021 and estimate its profit margin by dividing XRO’s “gross profit” by its
   “total revenue”.
   b. Determine the annual depreciation by assuming XRO depreciates the data center by the
   straight-line method over a 5-year life (both the estimated and the actual salvage values are
   zero).
   c. Assume that XRO’s effective tax rate is 30%. For simplicity, assume that the tax credit
   cannot be carried forward and XRO does not have any existing tax liabilities. Then calculate
   2
   tax expense for each year.
2. Determine the internal rate of return of the project using the Excel function.
   Section 2: Complete this section using Excel and report your answers in a Word document.
   Estimate the CAPM 𝛽 and Calculate Net Present Value Calculations as well as interest tax
   shield
3. Determine the cost of capital using data over the five-year period ending 31/12/2021 (i.e. 4/1/2017 – 31/12/2021).
   a. Using XRO daily stock price, All Ordinaries daily price and daily risk-free yield that are provided in the
   spreadsheet to compute CAPM 𝛽 . The 𝛽 can beestimated by regressing the XRO daily excess return on the
   daily market excess return. Present the graph with the best fitting line and a regression output table in your
   Excel sheet. Calculate the cost of equity using CAPM.
   b. Calculate the cost of debt by dividing the company’s “Interest Expense” by the “Long-term Debt” for
4. You may assume this cost of debt applies to this XRO’s new investment.
   c. Calculate the weighted average cost of capital (i.e., note that you should use the closing share price on 31
   December 2021 to calculate the equity weight in WWCC). You may assume the financing of the data
   center’s capital expenditure is in line with the XRO’s current capital structure. The ongoing cash outflows
   on expenses can be covered by the ongoing cash inflows, and thus no additional financing is required.
5. Calculate the NPV for this project.
6. Provide a sensitivity table for interest tax shield with the level of debt incrementing by 15%. Your starting point
   should be the actual level of debt that XRO adopts. You may assume that XRO is making nil profits on all other
   products/projects.
   Your sensitivity table should look like this:
   debt level Year 0
   ?%
   ?+15%
   ?+30%
   6+45?
   Section 3: Answer the following questions in a Word document. You do not need any
   references in answering these questions.
7. Compare the internal rate of return (IRR) and the weighted average cost of capital
   (WACC) of this project. Please explain what causes the difference between IRR and
   WACC in this particular project. Please provide reasons with respect to 𝑟𝑒
   (cost of
   3
   equity) and 𝑟𝑑 (cost of debt), separately.
8. Based on your answers in Q1 and Q2 of Section B, please analyze XRO’s current capital
   structure (i.e., please provide advantages versus disadvantages associated with XRO’s
   current capital structure choice based on Modigliani–Miller theorem). In addition,
   please illustrate what can you do to further optimize XRO’s capital structure.
9. Discuss how current rise in inflation and interest rate affects XRO's operation.
   Instructions:
10. You should name both your Excel and Word documents (i.e., your full name and
    student ID).
11. Your Excel file should contain 3 worksheets. Worksheet 1 is named ‘XRO financial
    statements’. You should copy the financial statements provided into this worksheet.
    Worksheet 2 is named ‘Data’, which contains the daily prices and returns (and excess
    returns) of XRO stock and S&P500. Worksheet 3 is named ‘Calculation’ and it should
    contain all your calculations for Sections 1 and 2