Question 3b
Amberle Co is a listed company with divisions which manufacture cars, motorbikes and cycles. Over the last few years, Amberle Co has used a mixture of equity and debt finance for its investments. However, it is about to make a new investment of $150 million in facilities to produce electric cars, which it proposes to finance solely by debt finance.
Project information
Amberle Co’s finance director has prepared estimates of the post-tax cash flows for the project, using a four-year time horizon, together with the realisable value at the end of four years:
| Year | 1 | 2 | 3 | 4 |
|---|---|---|---|---|
| $m | $m | $m | $m | |
| Post-tax operating cash flows | 28·50 | 36·70 | 44·40 | 50·90 |
| Realisable value | 45·00 |
Working capital of $6 million, not included in the estimates above and funded from retained earnings, will also be required immediately for the project, rising by the predicted rate of inflation for each year. Any remaining working capital will be released in full at the end of the project.
Predicted rates of inflation are as follows:
| Year | 1 | 2 | 3 | 4 |
|---|---|---|---|---|
| 8% | 6% | 5% | 4% |
| $m | |
|---|---|
| Bank loan, repayable in equal annual instalments over the project’s life, interest payable at 8% per year | 70 |
| Subsidised loan from a government loan scheme over the project’s life on which interest is payable at 3·1% per year | 80 |
150 |
Issue costs of 3% of gross proceeds will be payable on the subsidised loan. No issue costs will be payable on the bank loan. Issue costs are not allowable for tax.
Financial information
Amberle Co pays tax at an annual rate of 30% on profits in the same year in which profits arise.
Amberle Co’s asset beta is currently estimated at 1·14. The current return on the market is estimated at 11%. The current risk-free rate is 4% per year.
Amberle Co’s chairman has noted that all of the company’s debt, including the new debt, will be repayable within three to five years. He is wondering whether Amberle Co needs to develop a longer term financing policy in broad terms and how flexible this policy should be.
Required:
(b) Discuss the factors which may determine the long-term finance policy which Amberle Co’s board may adopt and the factors which may cause the policy to change. (10 marks)