FIN80005-Corporate Financial Management

Part 1

Bestfood is currently in negotiation with a large supermarket chain, 888Groceries Limited, to supply its Asian delicacy in a private label for 888Groceries. Under the terms, Bestfood is expected to supply Asian delicacy to 888Groceries every year for the next ten years. If Bestfood proceeds with the supply of delicacy, the company needs to purchase machinery to cope with the increase in production. New machinery is expected to cost $1,000,000 with an additional $150,000 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. For the new machinery, the company decides to use a depreciation rate of 5% per annum. It is expected that the new machinery can be sold for $200,000 at the end of its useful life.

If Bestfood is to proceed with the supply of delicacy to 888Groceries, it is expected that the yearly operating revenues would increase by $650,000 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. Fixed operating cost with the increased production is expected to be $200,000 per year. Variable operating costs associated with increased production is 20% of the increase in yearly operating revenues. However, as the private label delicacy’s selling price is cheaper than Bestfood’s brand, it is expected that Bestfood’s existing operating revenues would fall by $200,000 per annum and existing total operating costs would decrease by $80,000 per annum if Bestfood proceeds with the supply of delicacy. Moreover, there would be an initial increase in net working capital of $150,000. From year one to year nine, net working capital is expected to increase by $20,000 per year. All the net working capital can be recovered at the end of the project’s life.

The company requires you to calculate an appropriate discount rate using the company’s weighted average cost of capital. 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 2 FIN80005 19S2 the future. Given that the company is listed on the stock exchange, you are able to obtain the historical returns over the last 20 years for the company, the market portfolio and the risk-free asset as tabulated in Table 1. The company debentures have a face value of $1000 and a coupon rate of 10%. They mature in 5 years time. Similar debentures are currently yielding 11%. 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 delicacy 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 delicacy would be 30% higher than expected starting from year six. 

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, assume that Bestfood decides to proceed with the supply of private label delicacy to 888Groceries. As such, the company announces details related to the expected increase in profits and cash flows that it would achieve from the supply of private label delicacy. The table below shows the daily returns of Bestfood (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. 

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. Show all workings in the appendix of the report

Part 1

Show the various cash flows based on the different scenarios; assuming that the Bestfood decides to proceed with the supply of private label delicacy to 888Groceries; taking into consideration of the various scenarios. You should also clearly state any assumptions (if any) made in your analysis.

Part 2 Using Capital Asset Pricing Model (CAPM), calculate the daily abnormal return of Bestfood during the event window and plot the daily abnormal returns on a diagram. Daily abnormal return is computed as:

Abnormal Return = Actual Return − Expected Return  (

Discuss the abnormal return pattern of Bestfood 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; (2) recommendations to exploit mispricing opportunities, if any, from the perspective of the company; and (3) expectations of what would happen to the share price subsequent to the analyzed event window.