Question

1) Emeco Holdings Limited (Emeco) is a company listed on the Australian Securities Exchange (ASX). Emeco is investigating a proposal to replace one of their outdated earth-moving excavators with a new CAT 390F excavator. The new excavator has a much larger carrying capacity, offers improved fuel economy and has lower maintenance costs compared to the existing excavator. However, the cost of a brand new CAT 390F is $2.8 million and Emeco’s accountant is concerned that the net profit of the new excavator won’t generate a fast enough payback period. Therefore, the accountant has approached the Chief Financial Officer (CFO) to express concerns. The CFO carefully explains the many reasons that profitability is not a good measure of financial success, and stresses that the appropriate action is to conduct a rigorous cost-benefit analysis to determine if the new excavator can “… deliver on the outcomes desired by its shareholders …” (pg. 21, 2019 Annual Report) – namely, wealth creation.

2) Last month, Emeco paid for a study by an earthworks consultant at a cost of $487,000 and the study concluded that the large and growing infrastructure market will generate sufficient demand for a larger excavator. Today, Emeco must decide if they will proceed with the investment in the new excavator, and the simultaneous sale of their existing excavator.

3) According to the Australian Taxation Office (ATO) the new excavator has a sixteen-year life for taxation purposes.

4) Road and Maritime Services (RMS) requires that all heavy vehicles (including excavators) have a Certificate of Roadworthiness that indicates that the excavator has been inspected and found to comply with the minimum standards set out in NSW vehicle licencing legislation. The compulsory certificate is required before Emeco commences operations with the new excavator. Certification requires Emeco to spend $200,000 on safety equipment. The certificate expires four years later at which time the excavator must be recertified and the safety equipment replaced at an estimated cost of $200,000. Recertification must occur every four years. The safety equipment has no value in the secondary market.

5) According to the consultant, the new excavator could easily be operated for twenty years. However, Emeco will operate the excavator for ten years only. The existing excavator can be sold for $300,000 today. If Emeco don’t purchase the new excavator they will continue to operate the existing excavator for a further ten years. The existing excavator was purchased six years ago for $2 million. The annual depreciation expense of $200,000 per annum is based on the ten-year tax life at the time of purchase. The accountant consults Emeco’s fixed-asset register to confirm the current book value of the existing excavator is $800,000.

6) Some members of the Board suggest that as the new excavator is analysed over a ten-year time period Emeco must recover all the costs they have incurred to date. They recommend the $487,000 engineering consultant’s fee be allocated equally over the ten-year analysis period.

7) Emeco will borrow $2 million using a secured ten-year interest-only loan at an interest rate of 5% per annum to partly finance the new excavator. The loan requires annual interest payments of $100,000 starting in one year’s time. Today, inventory will need to increase by $110,000 to $610,000. Accounts receivable will increase to $750,000 from the current figure of $660,000.

8) The storage shed that Emeco constructed in 2018 at a cost of $675,000 will be retained whether Emeco purchases the new excavator or not. This shed is being depreciated over its 20- year life assuming a salvage value of zero. There is debate among the accountants if this item is an example of a sunk cost.

9) At the moment, the existing excavator generates annual cash sales of $1,700,000. This sales figure is predicted to remain constant for each of the next ten years. The new excavator is predicted to generate cash sales in year one of $2.4 million in year 1 and it is anticipated that this sales forecast will increase by 4% per annum for the foreseeable future.

10) The CFO has gathered some information regarding current and expected operating costs. At the moment, fixed costs are $400,000 per annum. Fixed costs would rise to $500,000 in year one with the new excavator and then continue to increase by 2% p.a. Wages expense is currently $900,000 each year and is predicted to increase to $1.4 million with the introduction of the new excavator. The CFO clarifies the importance of incremental cash flow items when performing a financial analysis.

11) The improved fuel economy of the new excavator will allow Emeco to reduce its current annual fuel expenditure by $60,000 compared to the existing excavator. The existing excavator was relatively fuel inefficient and used, on average, 290,000 litres of diesel fuel each year. The CFO assumes the cost of diesel fuel remains constant for the next ten years at $1.40 per litre.

12) The current annual maintenance cost of the existing excavator is $63,000. The new excavator will require no maintenance in the first three years of its life because it is covered by a manufacturer’s three-year warranty. However, after the warranty expires in year 4 the annual maintenance expense will be $87,000. Emeco has an umbrella insurance policy that will insure any number of the company’s excavators at a fixed annual fee of $145,000.

13) In 2017 Emeco issued $80 million of new shares through a rights issue and private placement. These funds were used to acquire a complementary business.

14) It costs $175,000 a year to operate Emeco’s Perth headquarters. With careful management Emeco believes they will not require any additional personnel in headquarters if they purchase the new excavator. In any case, the annual headquarters’ operating expense will increase by 3% p.a.

15) The ATO classifies the safety equipment required for the Certificate of Roadworthiness as a business expense. The accountant affirms that any expenses incurred in generating sales for Emeco are tax deductible in the year the expense is incurred.

16) The earthwork consultant’s report estimates that the new excavator will have a market value of $1.1 million in ten years’ time. The existing excavator can be sold for $300,000 today. Emeco will use these sale proceeds to reduce its bank debt by $300,000 today. The consultant advises that in ten years’ time the existing excavator would be worthless.

17) The company tax rate is 30% and the required rate of return is 9%.

Present an itemised breakdown (and the total) for each of the following into the spreadsheet:

1. The cash flows at the start.

2. The cash flows over the life.

3. The cash flows at the end.

4. The NPV of the new excavator and an explanation of your recommendation.

Financial Information

5. According to Emeco’s 2019 Annual Report, what is one benefit of the large cash flow that Emeco produced in 2019? (1 mark)

6. Offer one explanation why Emeco has not paid any dividends to its shareholders for at least five years. (1 mark)

7. According to page of Emeco’s 2019 Annual Report the Managing Director anticipates that Emeco will reach its goal “to be able to pay a dividend to shareholders.” Assume that Emeco pays a five-cent dividend in 2021. Further assume this dividend will increase by 40% to seven cents in 2022, and then the dividend is ten cents in 2023. After 2023 the annual dividend will continue to increase at a 4% rate forever. Using a 9% required return, what is a theoretical price today, in 2020, for one share of Emeco? (3 marks)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 1. Cash Flows at the start STUDENT NUMBER TEAM MEMBER NAME (TEAM LEADER) Total Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 2. Cash Flows over the life Total Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 3. Cash flows at the end Total Grand total for each year 4. NPV Recommendation 5. Cash flow benefit 6. Explanation for no dividends 7. Theoretical Share Price

Answer 1

Answer 1,2,3 and 4

Cash Flow at the Start
Year	0	1	2	3	4	5	6	7	8	9	10
Cost of Excavator	-2800000
Cost of Certificate	-200000
increase in working capital	-200000
Sale of Existing Excavator	300000
Tax Benefit on Excavator Sale(800000-300000)*30%	150000
Total Cash Flows	-2750000
Cash Flow over the Life
Year	0	1	2	3	4	5	6	7	8	9	10
Sales		2400000	2496000	2595840	2699674	2807661	2919967	3036766	3158236	3284566	3415948
Cost of Certificate Renewal					-200000				-200000
Depreciation		-175000	-175000	-175000	-175000	-175000	-175000	-175000	-175000	-175000	-175000
Interest on Loan		-100000	-100000	-100000	-100000	-100000	-100000	-100000	-100000	-100000	-100000
Fixed Expenses		-500000	-510000	-520200	-530604	-541216	-552040	-563081	-574343	-585830	-597546
Wages Expense		-1400000	-1400000	-1400000	-1400000	-1400000	-1400000	-1400000	-1400000	-1400000	-1400000
Fuel Expense		-346000	-346000	-346000	-346000	-346000	-346000	-346000	-346000	-346000	-346000
Operating Expenses		-175000	-180250	-185658	-191227	-196964	-202873	-208959	-215228	-221685	-228335
Net Profit		-296000	-215250	-131018	-243158	48480	144054	243725	147666	456051	569067
Tax Expense		-88800	-64575	-39305	-72947	14544	43216	73118	44300	136815	170720
After tax profit		-207200	-150675	-91712	-170210	33936	100838	170608	103366	319236	398347
Add: Depreciation		175000	175000	175000	175000	175000	175000	175000	175000	175000	175000
Cash Flows		-32200	24325	83288	4790	208936	275838	345608	278366	494236	573347
Cash Flow at the end
Year	0	1	2	3	4	5	6	7	8	9	10
Sale of new excavator											1100000
Tax on sale of excavator											-15000
total Cash Flows											1085000
Grand Total of Cash Flows	-2750000	-32200	24325	83288	4790	208936	275838	345608	278366	494236	1658347
DF @9%	1	0.917	0.842	0.772	0.708	0.65	0.596	0.547	0.502	0.46	0.422
PV	-2750000	-29527.4	20481.65	64298.14	3391.081	135808.6	164399.2	189047.4	139739.7	227348.5	699822.3
NPV	-1135191

New excavator should not be purchase as it has Negative NPV and will generate wealth for the company.

Answer 5

Large cash flow will benefit the wealth creation for investors.

Answer 6

Being Emeco is able to investment money at better rate of return than investors can invest somewhere else.