The Managing Partner of High End Strategy (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 Procession Precision Engineering Pty Ltd (PPE).

Niko-san, the management team and the Board at PPE 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 intend to 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.

Niko-san has now asked your managing partner to provide advice with respect to whether the expansion opportunities are worthwhile.

Niko-san has had additional discussions with new potential clients, and has confirmed that on top of current activities, the company has in his view a real opportunity to pick up regularly an additional 3- 5 projects per year, all of which will have one year duration on average, and it would appear that the clients would be prepared to pay somewhere between ¥30-50 million for successful completion of each project. As noted he will need to expand his space should he proceed, and will also need to invest in new equipment – at an estimated cost of need to spend ¥93.5 million in terms of equipment (which has a 4 year depreciation life) and also get his employee skills up to scratch with some new technology, so is proposing employee training of ¥25 million to facilitate the provision of the services, to occur in the first year of operations. In anticipation of the expansion he has committed to providing the training to his current employers in the next two months, and signed a contract for half the cost. He has liaised with various suppliers, and paid a consultant ¥5 million to establish the specifications of the equipment (and source suppliers).

PPE’s 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 an
additional high level and experienced manager – at 15% more per manager than it currently pays, but also employ 2 administrative support personnel (with average salaries 75% of the current management team). With Niko-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 (perhaps by 5%). There are expected to be 3-5 people needed per project won for production activity.

You have done some preliminary research with respect to defining an appropriate discount rate to use in the calculations. You have identified a similar, but somewhat bigger publicly listed company

operating in Japan – and PPE aspires to match its performance. The following information is available for the company:

• It has debt to equity ratio of 1:4.1
• Yahoo finance has quoted a beta for it of 1.35
• It has current share price of ¥115, and a price to earnings ratio of 3.6
• It has not been paying any dividends over the last five years as it has invested in forthcoming growth, and will continue to do that over the next three years (ie end of 2020 -2022). Then it expects to pay a dividend per share of ¥9 for two years (end of 2023 and 2024), and then increase it to ¥18, after which it expects the company to stabilise and dividends to grow with inflation
As PPE is a private company there is no market led information to derive the cost of capital, so you intend to use the above as an indication of PPE’s cost of capital – but would like to test the consistency of the market information (you will need to do some research). Further Niko san has acknowledged from discussion with banks that is debt options are more limited and as such at best have 20% of its balance sheet funded by debt in the long term.

Niko-san has also briefed the managing partner that he has been in discussions with another new potential client that has approached him re a possible project in developing precision tooling equipment to be used in high end manufacturing plants – something that will extend PPE’s capacity, but is a riskier activity for PPE as it is a somewhat new field, and in addition is something a bit different to what they currently do. The client believes PPE’s high quality achievements in what they do now means that he wants to work with them on this. You have the following preliminary information about the project:

• The client needs 4 specialised tooling machines to be produced over the next 4 years. He can buy something similar to what he needs from a South Korean supplier for ¥65 million, but has indicated he is prepared to pay about a 25% 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 each of the next two years.
• It is noted the potential South Korean supplier is an all equity business which you have been told has an indicative beta of 1.5.
• 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 per person of ¥6.76 million.
• The high end electronics for each machine will be subcontracted out, and you have been quoted around ¥11.35 million per machine.
• The labour and these inputs are the major costs, while other inputs will be around 25% of that.
• To undertake the project, PPE will allocate some spare space in their current premises. Niko-san has been offered ¥4 million per year if PPE would lease this space to one of their core suppliers.
• There will be a dedicated management team applied of 2 people with an average salary of
¥9.63 million (Niko san will also need to oversee and act as mentor to these people – he expects it to take about 15% of his time over the first year, and 10% thereafter).

• Other costs (cleaning, security, power, consumable) are expected to be of the order of ¥2.35 million per year
• To undertake the project will need to buy further specialised equipment at an estimated cost of ¥112 million, with set up costs of 10%. You will also need working capital of about 15% 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 of 15% 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 Japanese company. Provide advice as to whether you should undertake the project, and an indication of the minimum and maximum premium over the South Korean company price you would be prepared to negotiate around.