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Case Study

The Investment Detective

The essence of capital budgeting and resource allocation is a search for good investments in which to invest the firm�s capital. The process can be simple when viewed in purely mechanical terms, but a number of subtle issues can obscure the best investment choices. The capital budgeting analyst is necessarily, therefore, a detective who must winnow good evidence from bad. Much of the challenges is knowing what quantitative analysis to generate in the first place.

Supposed you are a new capital budgeting analyst for a company considering investments in the eight projects listed in Exhibit 1. The chief financial officer of your company has asked you to rank the projects and recommend the "four best" that the company should accept

Part I

For the first part of this assignment only quantitative considerations are relevant. No other project characteristics are deciding factors in the selection, except that management has determined that projects 7 and 8 are mutually exclusive.

All projects require the same initial investment, $2,000,000. Moreover, all are believed to be of the same risk class. The weighted average cost of capital for the first part is 10%. To simulate your analysis, consider the following questions:

Can you rank the projects simply by inspecting the cash flows?

What criteria might you use to rank the projects? Which quantitative ranking methods are better? Why?

What is the ranking you found by using quantitative methods? Does this ranking differ from the ranking obtained by simple inspection of the cash flows?

What kinds of real investment projects have cash flows similar to those in the exhibit?

Part II

The company has the following capital structure:

Account

$

Costs before tax

Long-Term Debt

1,500,000

10%

Preferred Stock

500,000

12%

Common Stock

3,000,000

20%

Calculate the weighted average cost of capital (tax is 40%)

Using the same cash flows in exhibit I find the NPV, PI,IRR and MIRR (Use your answer on part one as cost of capital). Which project(s) would you recommend and why?

Part III

Based on the following information and data in part II prepare Performa income statement. Also, calculate the DOL, DFL, and DTL and earning per share.

Q=20,000 units

Price=$120

VC=$80

Fixed cost=$450,000

100,000 outstanding shares

Assume that the management has a target DTL of 6. How much debt needs to be retired (replace by common stocks) in order to achieve that goal? What would be the new WACC?

Exhibit Project cash flows in (00)

Project1

Project2

Project3

Project4

Project5

Project6

Project7

Project8

Initial Investment

$2,000

$2,000

$2,000

$2,000

$2,000

$2,000

$2,000

$2,000

Year

1

$330

$1,666

$160

$280

$2,200

$1,200

$(350)

2

$330

$334

$200

$280

$900

$(60)

3

$330

$165

$350

$280

$300

$60

4

$330

$395

$280

$90

$350

5

$330

$432

$280

$70

$700

6

$330

$440

$280

$4,000

$1,200

7

$330

$442

$280

$2,250

8

$1,000

$444

$280

9

$446

$280

$2,000

10

$5,000

$448

$280

11

$450

$280

12

$451

$280

13

$451

$280

14

$452

$280

15

$9,000

$(2,000)

$280

Sum of Cash Flow

Benefits

$3,310

$7,165

$9,000

$3,561

$4,200

$6,200

$4,560

$4,150

Excess of cash flow

Over investment

$1,310

$5,165

$7,000

$1,562

$2,200

$4,200

$2,560

$2,150

Yellow/italics indicate year in which payback is accomplished

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Nestor Rutherford
Nestor RutherfordLv2
28 Sep 2019

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ATC Corporation is a manufacturer of new and replacement parts for the aircraft industry. The company’s major customers are airlines, other aircraft operators (such as charter services), and contract maintenance service providers. Despite the economic slowdown, the company expects its sales to be strong for the several years, since many aircraft operators will be more interested in maintaining and repairing existing planes rather than buying new ones. At the present time, ATC is considering an upgrade to its manufacturing facility. This will involve replacing several older machines by the purchase and installation of a new, state of the art, computer-controlled metal cutting and shaping machine center made by a German supplier. Estimates of the machine center’s costs and benefits are shown in the table below, where net cash flows are after-tax. Although the machinery should last for at least ten years, the company uses a five-year planning period for equipment of this type (based on depreciation rules and company policy). Since the machine will not be sold at the end of year 5, there is no salvage value to consider. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Initial Costs: Purchase -3,600,000 Shipping -150,000 Installation -250,000 Cash Inflows: Sale of Old Machines 200,000 Investment Tax Credit 350,000 After-Tax Cost Savings 400,000 420,000 440,000 460,000 480,000 After-Tax New Sales 0 50,000 100,000 120,000 150,000 Depreciation Tax Savings 350,000 600,000 430,000 300,000 200,000 Increased Product Quality 10,000 20,000 25,000 30,000 35,000 Net Cash Flows: -3,450,000 760,000 1,090,000 995,000 910,000 865,000 Three important things to note are that the above cash flows have been adjusted to include an assumed inflation rate of 3% per year, the company’s average tax rate is 30%, and that the investment project is considered to be 20% riskier than the company’s average investment. Examination of ATC’s balance sheet reveals that the company uses the following types of financing (all percentages are based on market value). Financing Type Percentage of Total Financing Market Rate of Return Short-Term Debt 15% 3.5% Long-Term Debt 30% 5.25% Preferred Equity 10% 8% Common Equity 45% 12% If ATC does not make this equipment investment, it has no other real asset investment projects which it is considering. Therefore, an alternative use of the money in the capital budget would be a purely financial investment, such as stock, bonds, short-term CD’s, and so forth. 1. Based on your knowledge of current and projected economic conditions, does the company’s assumption about future sales sound reasonable to you? Why or why not? 2. What cost of capital should the company use to analyze this investment project? 3. Without considering any other alternatives, is the machine a good investment for the company? Why or why not? 4. Without doing any calculations, discuss some possible alternatives which the company might have in terms of financial investments. Give some specific examples and make sure that you include a consideration of risk as part of your discussion. 5. Which choice would you recommend for the company? Why do you consider this option the best choice? 6. Suppose you are convinced that inflation over the next several years will be higher than the 3% which is forecast in the numbers the company is using in their projections. Without doing any further calculations, explain how you could adjust your analysis to account for this.

IRJAF-Toruga Actions for 'IRJAF-Toruga'

Abstract This case study on project evaluation is applicable for beginning courses in corporate finance or finance strategy. Two alternative investment options are available to evaluate. Challenges are presented with the inclusion of equity, bank debt, and bonds in the capital structure. Each investment option need to be evaluated carefully and decision should be made on the basis of thorough analysis of the data available using various capital structure and capital budgeting techniques. Keywords: Beta, Corporate Finance, Cost of Capital, Internal Rate of Return, Net Present Value JEL Code: C10, G31, G32

Introduction

Brooks Hamilton recently accepted a job with Tortuga Fishing Equipment Company1 (Tortuga) in the company’s finance department. His first few assignments were fairly straightforward and Brooks relied on his background in both accounting and finance to get his career off to a great start. His manager, the company’s Chief Financial Officer (CFO) was impressed with his work and decided to put Brooks on a new assignment. The firm was embarking on a new project which would define its future over the upcoming years. Given the importance of the project and high degree of visibility with the firm’s senior management, Brooks was flattered to be asked to assist and eager to show that he was up to the task. The finance department was tasked with preparing an analysis to make a decision between two competing project plans which could very well decide the future of Tortuga in the competitive fishing equipment industry. The Chief Executive Officer (CEO) wants to have an answer from finance and expects a thorough analysis very quickly.

The Company

Tortuga is an Islamorada, Florida based company specializing in manufacturing high-end fishing rods and reels. Tortuga was founded by a retired university professor who fished all of his life and wanted to create the best equipment possible to handle a variety of fishing conditions and fish species. He partnered with an engineer who ran a machine shop to produce some prototype reels and supplied these to commercial fishing captains as test market research. The equipment produced by Tortuga was a significant improvement over the current line available and orders were strong. Through the years, the company made some modest improvements to their original prototype and had become an industry leader. Tortuga’s products are used by tournament fishing teams around the world. Over the past decade, tournament fishing has grown to become a big business with corporate endorsements and prize money. This growth has made what was once a recreational vocation into a full-time profession for some anglers. The company recently launched an extensive research and development effort focused on a new flyrod and reel designed for one particular species of fish, the Atlantic Tarpon (Megalops atlanticus). Tarpon are long-lived fishes that migrate in the warmer climes of the Caribbean Sea, Gulf of Mexico, and along the Atlantic Ocean coastlines. Although the fish can reach lengths of eight feet (~2.4 meters) and weights of 280 pounds (127 kilograms), they inhabit the shallow flats and exhibit acrobatic leaps when hooked. These traits make tarpon a popular game fish for anglers. Fishing gear needs to be sturdy to handle the power of these fish and Tortuga had developed products for this niche market which were allowing anglers to be successful in their angling pursuits. Recently, several sponsors had come together to launch competitive angling events called tournaments, where the best anglers vie to catch, and then release, the most and largest tarpon. Winners may receive up to $50,000 in a single weekend tournament and the difference between winning and losing could be a few pounds. With so much money at stake, tournament teams purchase the best gear available and are always looking for any competitive advantage with their equipment. Tortuga is looking to capitalize on this trend by offering a new line called the Tortuga Tarpon Classic. This new line incorporates the latest material and design improvements and is predicted to be the “gold standard” for all serious tournaments anglers. Tortuga plans to offer the Tortuga Tarpon Classic to recreational anglers as well to capture the growing demand by affluent anglers who want the same high-quality gear as the professionals.

Financial Information

Tortuga began with a modest amount of capital that the founder had managed to save during his years in academia. As the firm grew, its financing needs expanded as well. Through the years Tortuga had developed and maintained a strong relationship with a large bank which provided short-term working capital funds in the form of a revolving line of credit. When a funding need arose, Tortuga would draw from this line of credit and then repay the short-term draw as cash flowed back to Tortuga. The $200 million revolving line of credit currently has $25 million drawn at an interest rate of 3-month Libor plus 350 basis points2. The remaining $175 million credit line can be assumed to have no fees associated with it3. Brooks looks up the most recent 3- month U.S. dollar Libor rate and sees that it is 1.50%. Long-term financing was also in place in two forms. After several years of revenue and earnings growth, Tortuga issued five million shares of common stock at an issue price of $10 per share. The firm used this $50 million in funding to increase production lines and build a global presence by opening an additional manufacturing facility in Panama. Brooks finds the current price per share for Tortuga to be $16. Two years ago, Tortuga issued a 10-year bond for $50 million face value. Each $1,000 par bond carries a coupon of 8.5%. The bond pays interest semi-annually and is currently trading in the market at 102.50 as a percent of par. The company has a 34% corporate tax rate. The firm calculates its required return on equity with the Capital Asset Pricing Model (CAPM) using a 4.0% historical Treasury rate for the risk-free rate and 6.0% as the historical market risk premium4. CAPM = Risk-free rate + beta (Market Risk Premium) The annual stock returns versus the market are shown in Figure 1 below for the past 10 years. Beta is calculated by regressing Tortuga stock returns on the Standard & Poor’s (S&P) 500 returns. There are a variety of methods for calculating beta. Brooks could find beta by regressing five years of weekly Tortuga returns of the S&P 500. He could use five years of monthly returns or two years of weekly returns. Each of these is a valid sample period. One well-known data source provides an “adjusted” beta which is determined by first calculating a “raw” beta by regressing two years of weekly security returns on the market. This is then adjusted by taking 2/3 of the raw beta plus 1/3 of one. This adjusts the beta to be closer to one, since beta is not stationary and should naturally move towards one through time as a firm expands. Brooks only has 10 years of annual data available at the time and decides to conduct the analysis with this information to get a quick response. He will check his result with more data points before submitting his final report to the CFO.

Figure 1 Returns on Tortuga Stock versus the Standard & Poor 500 Year Tortuga Return S&P 500 Return Year Tortuga Return S&P 500 Return 1 12 7 2 22 16 3 -2 -3 4 14 9 5 9 8 6 19 21 7 16 17 8 -10 -5 9 7 9 10 12 14 Source: Author After Brooks calculates beta he employs formula (1) above along with the risk-free rate and market risk premium to determine the cost of equity. The firm’s weighted average cost of capital is a function of its equity market capitalization, cost of equity, short- and long-term debt amounts and costs, and the tax rate. Using formula (2) below, Brooks can find the firm’s weighted average cost of capital (WACC). WACC = Rd * D + Re*(E/D+E) where: WACC = weighted average cost of capital Rd = Cost of Debt Rd1 (1-marginal tax rate) Rd1= Company’s before tax rate D= weighted percent of debt E= weighted percent of equity Re = Cost of equity Rf +B*(Rm-Rf) Rf= risk free rate B= Beta, the owners will need to calculate beta Rm= equity risk premium Tortuga Tarpon Classic The company has two separate research teams working on the project and they develop two distinctly different fishing combinations. The two rod and reel combinations are test marketed with guides and past tournament champions and demand forecasts are determined. Most fishing gear has a relatively short life due to continual product innovation. Manufacturing of the two combinations is estimated to require an upfront cost of $5 million to retool the machine shop. The process for manufacturing the two combinations differ and ongoing variable costs are not the same. The net cash flows for the entire ten year expected life of the product is shown in Table 2 as Project A and Project B (all figures are $thousands of net cash flow). Project A focuses on hand tooled fishing equipment which results in a more labor intensive process, but also allows for personalized features for customers. The price charged for customization offset the slower hand tooling process to generate substantial net cash flows. Part of the upfront $5 million includes the costs of training more machinists in the art of hand tooling, which is similar to watch making but with a few less moving parts. Project A is anticipated to generate lower cash flows in the early years due to the length of time required to get machinists who are adept at hand tooling to customer specifications. In fact, during the first year there will be continued expenses to attain these skills which causes year one net cash flows to be negative. Over time the cash flows increase as more machinists gain proficiency. The project is expected to experience lower cash flows towards the end of its life due to market saturation. Due to the quality of the reels, they are built to last and seldom fail or wear out. Technological obsolescence is certain although Tortuga will be investing cash flows into research and development to launch the next generation at the conclusion of the Tortuga Tarpon Classic life cycle. Project B employs a mechanized approach to large scale production of standardized equipment. Although the approach does not allow for personalization, it does allow Tortuga to build its inventory quickly and capture positive net cash flows immediately. The upfront expense is almost completely devoted to tooling equipment procurement and the number of units produced will be much higher and at lower price points than the approach of Project A. At the end of both projects life it is assumed that there will be zero salvage value as the pace of innovation will require a complete re-tooling for the next generation and the useful life of the equipment will have been fully realized. Brooks realizes that he will need to calculate the firm’s cost of capital discount rate and apply this to the cash flow projections of both projects. He recalls all of the assignments he completed at university and is thankful to have been so well-prepared for this task. He gets a cup of coffee, sits down at his desk, and gets to work. Figure 2 Project Net Cash Flows for Tortuga Fishing Equipment ($thousands) Year Project A Project B 1 -900 950 2 200 950 3 900 950 4 1800 950 5 2500 950 6 2500 950 7 1800 950 8 1200 950 9 800 950 10 200 950 Source: Author Since Brooks is new to his role, you have been asked to review his work and assess the financial viability of the projects. Given the importance of this decision you are helping to make sure the firm makes the right choice. Notes: 1. Fictitious company created to illustrate corporate finance principles. 2. Libor is an acronym for London Interbank Offered Bank, which is a standard floating interest rate benchmark for credit facilities. A basis point is equal to 1/100th of 1%. One percent is 100 basis points. 3. Typically a bank will charge a facility fee for the entire credit facility, $200 million in this case and an interest rate based on utilization. We assume no facility fee for simplicity. 4. The risk-free rate is determined based on the geometric average of the long-term Treasury. The market risk premium is calculated based on the difference between the geometric return on the Standard & Poor’s 500 index and the long-term Treasury.

Specific Questions 1. Using the Capital Asset Pricing Model, what is the required rate of return on equity, E (cost of equity) for Tortuga? 2. what are the weights of equity and debt in the capital structure? (Rd & Re) 3. Using the information provided, what is the firm’s weighted average cost of capital (WACC)? 4. What are the net present value (NPV), internal rate of return (IRR), and Payback Periods for Projects A & B? 5. What decision rules will you use to help Tortuga reach a decision? 6. What are the strengths and weaknesses of each of the evaluation tools?

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