Advanced Business Finance

The topic for Critical Report and Oral Presentation:

Capital Budgeting for a Project with Timing Option

Synopsis and Objectives

Mainfreight New Zealand is a publicly listed company that offers freight transport and warehousing services locally and abroad through international alliances. Suppose the company owns a piece of land with an old building near the Auckland International Airport. The building and the land have a current appraised market value of $15 million, and the building is currently used as a warehouse generating a perpetual gross annual rent of $600,000. As the rental contract is going to expire soon, the company is considering the option of using the site and the building for an expansion of its logistic business. In that case, the company will need to get the building refurbished and re-configured. The refurbishment and preparation for the logistic business will cost $7,000,000 and take one year to complete.

An international logistic company has promised Mainfreight an additional subcontract of $5,000,000 worth of business each year should the company decides to go ahead with the expansion plan. The variable cost of operation is 65% of the annual revenue and the incremental fixed cost is estimated to be $2,500,000 a year. It is also estimated that the business expansion will have a 40 percent chance to generate an additional $4,000,000 local business, and a 30 percent chance to generate an additional $8,000,000 local business, in addition to the incremental subcontract with the international player. The chance of not getting any incremental business from the local market is 30 percent.

This project can be delayed for one year, and the cost of expansion, incremental revenue, and cost forecasts for different scenarios will remain the same as projected. Suppose the uncertainty about the incremental demand in the local market will only last for one year. As the economic condition stabilizes over the next year, the company will be able to know exactly how high the incremental revenue is going to be at the end of year one.

Assume the business expansion, once established, will last forever. The initial cost for setting up the expansion of business can be fully depreciated over 10 years using the straight-line method. The value of land will be preserved at its current market value, but may not be depreciated for tax reasons. The risk-free interest rate is 3 percent (1-yr treasury rate, compounded annually). The corporate tax rate is 28 percent, and the cost of capital is 10%. A summary of the key inputs for project analysis is provided in an Excel file.

As trained financial analysts, you and your teammates are assigned a task to check whether it makes financial sense for the company to use the building and the site for expanding its logistic business. Conduct a thorough project analysis, write a report to

present your finding, and make a recommendation to the company's board of directors in two weeks. The written report should include at least three sections: an executive summary, analysis, and conclusions/recommendations. The report should be self-contained: it should provide sufficient information to allow readers to understand your arguments without having to refer to your work in the Excel spreadsheet.

List of tasks and questions suggested for discussion in your report:

Draw up a summary of the logistic business annual net operating cash flow.

Find out the value of the proposed business expansion if it is implemented today.

Examine which factor, annual revenue, variable cost, or cost of capital, is the most influential factor for the investment's success?

Find out the NPV of the business expansion if it is implemented a year later.

Use decision tree analysis to determine the value of the investment timing option.

Use the Black-Scholes Option Pricing (BSOP) model to estimate the value of the investment timing option. Specify the values of input variables used for your application of the BSOP. Explain in detail your procedure of estimating the risk of returns for the underlying asset of the real option.

What conclusion can you draw from the results of your analysis?

Make sure you:

Complete signing up for a group of your choice (on Stream site under the

All group members are required to contribute to the writing of the report. Note the name of the writer of the section at the beginning of each section.

The total length of the group report must not exceed 8 pages (including tables, graphs, appendix, and the title page).

Based on the content of your written report, prepare PPT slides and record a video group oral presentation. Note that you also need to show your webcam in the recordings.

Each group member must complete a Teamwork Evaluation sheet and submit it on Stream together with the recorded presentation by the due date of the presentation.

You must submit a completed Teamwork Evaluation sheet to receive a grade for the Critical Report assessment.