Please answer the following case study.
The Managing Partner of the corporate advisory firm in which you work was very pleased with your work in preparing a briefing paper for the initial meeting with a new client – Health High Precision Tools Pty Ltd is (HHTP).
Hiro-san, the management team and the Board at HTTP have taken heed of your advice. At the moment the board has decided to stay as a private limited liability company – and to facilitate the expected growth raise the extra capital as a combination of debt and equity (by inviting some new investors to provide the new capital, and replace the existing shareholder who wants to withdraw). The board has also confirmed that it will take on the lease rather than commit to the substantial increase in debt that would come with purchasing a property. The board discussed your advice, and is not prepared to take on the property market risk – as property markets are an area it does not have expertise in.
Hiro-san has asked your managing partner now to provide advice with respect to a number of specific issues.
1. A similar, but somewhat bigger publicly listed company operating in Japan has been identified – and HTTP aspires to match its performance. The following information is available for the company:
o It has debt to equity ratio of 1:4.6
o Yahoo finance has quoted a beta for it of 1.5
o It has current share price of ¥141.13, and a price to earnings ratio of 4.1
o It has not been paying any dividends over the last five years as it has invested in forthoming growth, and will continue to do that over the next three years (ie end of 2018 -2020). Then it expects to pay a dividend of ¥13 (end of 2021), and then increase it to ¥23, after which it expects the company to stabilise and dividends to grow with inflation
Based on this information, comment on the consistency of the market valuation of the company and its implications for HTTP (note you will need to look up or makes some assumptions about market information to do this).
Using this information as a base, and an acknowledgement that HTTP recognises it has limitations in using debt and as such will at best have 20% of its balance sheet funded by debt in the long term – provide advice as to the cost of capital to be used as a discount rate in company and project valuations.
2. After discussion with a range of potential clients, Hiro-san has confirmed that on top of current activities, the company has in his view a real opportunity to pick up regularly an additional 3-4 projects per year, all done within a year, and averaging between ¥75-100 million in turnover per project. He is therefore proposing that the company will need to spend ¥135 million in terms of equipment (which has a 4 year depreciation life) and new employee training of ¥35 million to facilitate the provision of the services, to occur in the first year of operations. He has liaised with various suppliers, and paid a consultant ¥8 million to establish the specifications of the equipment (and source suppliers), and subsequently a non refundable deposit of ¥15 million to the training provider to commence preparation of the materials. The Board discussed your observations in the previous advice with respect to the how much “growth” in activity this represents for the company, and the associated risk in managing it, and therefore it expects to have to increase the size of the management team – it expects to hire 3 additional high level and experienced managers – at 15% more per manager than it currently does, and 3 administrative support (with average salaries 2/3 the current management team. With Hiro-san’s less direct involvement, it is expected that the ability of the production team will need to be lifted, and as such the average wages in this context will need to be increased (also perhaps by 10%). The number of production people you would need is expected to increase proportionally (new revenue relative to current revenue). Using this information and some other assumptions, how much would you expect this outlooking changing the value of the company. Is this growth worthwhile for the existing shareholders in the company (and does it change your opinion about the buy out value for the shareholder who wants to withdraw).
3. Hiro-san has also been in discussions with a new potential client have identified a new possible project in developing precision tooling equipment to be used in high end manufacturing plants – something that will extend HTTP’s capacity, but is a riskier activity as it is a somewhat new field, and in addition is something a bit different to what they currently do. The client believes their high quality achievements in what you do now means that he wants to work with you on this. You have the following preliminary information about the project:
o The client needs 4-5 specialised tooling machines to be produced over the next 5 years. He can buy something similar to what he needs from an American supplier for ¥75 million and has indicated he is prepared to pay about a 20% premium for something that more directly suits his needs, and can be serviced locally. You have discussed providing 1 in the first two years and then 1 in the next year and then 4 over the remaining two years.
o It is noted the American company is an all equity business which you have been told has an indicative beta of 1.5.
o You will need 3-4 person years to construct each machine on average (at the higher end for the first machine, as the workforce needs more training, and at the lower end subsequently) – with an average wage of ¥6.56 million.
o The high end electronics for each machine will be subcontracted out, and you have been quoted around ¥12.54 million. The labour and these inputs are the major costs, while other inputs will be around 30% of that.
o To undertake the project, HTTP will allocate some spare space in their current premises. Hiro-san has been offered ¥3 million per year if HTTP would lease this space to one of their core suppliers.
o There will be a dedicated management team applied of 2 people with an average salary of ¥9.23 million (Hiro san will need to oversee and act as mentor to these people – he expects it to take about 20% of his time over the first year, and 10% thereafter).
o Other costs (cleaning, security, power, consumable) are expected to be of the order of ¥3.25 million per year
o To undertake the project will need to buy specialised equipment at an estimated cost of ¥152 million, with set up costs of 20% (and you have already spent about one fifth of that in preparing the information above). You will also need working capital of about 25% of the projects annual operating costs. The equipment has a tax deprecation life of 4 years, but can be used for the full length of the project, with an expected disposal value o f20% of the purchase price at the end of the project.
Despite the statements made by the potential client that they have come to you because of your quality reputation you suspect that they are also talking to another company. Provide advice as to whether you should undertake the project, and an indication of the minimum and maximum premium over the American company price you would be prepared to negotiate around.