Riverlea Limited is a public listed company that specialises in the production of confectionery. The production relies heavily on the use of machine. The number of shares outstanding of the company is 100,000.
Riverlea is currently in negotiation with a large supermarket chain, Wowcoles, to supply its confectionery in a private label for Wowcoles. Under the terms, Riverlea is expected to supply confectionery to Wowcoles every year for the next ten years.
If Riverlea proceeds with the supply of confectionery, the company needs to purchase machinery to cope with the increase in production. New machinery is expected to cost $1,300,000, with an additional $200,000 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.1 It is expected that the new machine can be sold for $200,000 at the end of its useful life.
If Riverlea is to proceed with the supply of confectionery to Wowcoles, it is expected that the yearly operating revenues would increase by $720,000 and remain constant at that level, while operating costs associated with increased production would be constantly $200,000 per annum. However, as the private label confectionery’s selling price is cheaper than Riverlea’s brand, it is expected that Riverlea’s existing operating revenues would fall by $150,000 per annum and existing operating costs would decrease by $50,000 per annum if Riverlea proceeds with the supply of confectionery. Moreover, there would be an initial increase in net working capital of $50,000. The net working capital can be recovered at the end of year ten.
The company requires you to calculate an appropriate discount rate using the Capital Asset Pricing Model (CAPM). Riverlea is an all-equity firm with an equity beta of 1.20. Riverlea has decided to use ASX200 index to represent the market, and the 90-day Australian Treasury Bill as a proxy for risk free asset. Based on the current state of economy, Riverlea has determined that the expected return on ASX200 is 15% per year, and the 90-day Australian Treasury Bill rate is 4.50% per year. 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 confectionery would be 20% lower than expected starting from year six;
2) Allow for a 20% probability that incremental revenues associated with the supply of private label confectionery would be 20% higher than expected starting from year six.
You are to prepare a spread sheet, to present to the CEO, showing the various cash flows based on the different scenarios; assuming that the company decides to proceed with the supply of private label confectionery to Wowcoles.
Use Excel to prepare a full analysis, evaluating whether or not the company should proceed with the supply of private label confectionery to Wowcoles, taking into consideration the various scenarios.
Show all formulae, adjacent to the corresponding calculated amounts in the spread sheet.
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 the company decides to proceed with the supply of private label confectionery to Wowcoles. As such, the company announces details related to the increase in profits that it would achieve from the supply of private label confectionery. The table below shows the closing stock price of Riverlea 5 days before and after the announcement. Day 0 is the day of the announcement and assume that there is no other price-sensitive announcement within the event window.
Stock Price ($)
Plot the stock price of Riverlea 5 days before and after the announcement. Discuss the stock price behaviour of Riverlea 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 recommendations of a trading strategy to exploit mispricing opportunities, if any, and expectations of what would happen to the share price subsequent to the analysed event window.
Hint: Based on the analysis conducted in Part 1, evaluate the extent to which stock price is expected to increase or decrease on the day of the announcement.