Question

Heavy Keele Ltd. (HK) has a long-standing reputation as a manufacturer of quality sailboats. HK currently produces two different models of sailboat from a single production facility — the HK41 and the HK49. The past several years have seen a 25% decline in demand for HK’s sailboats and a significant increase in interest within the boating community for motor vessels. Given this shift in attitudes, HK is now considering a proposal to introduce a motor vessel into its product line — the HKMV55.

If the proposal is accepted, senior management has decided to restructure the firm into two separate divisions for operational purposes — the Sailboat division and the Motor Vessel division. Under the proposal, all current personnel will remain with the Sailboat division and the senior management team will remain unchanged. For accounting purposes, however, the $2 million annual cost of the senior management team will be allocated equally between the two divisions. HK will then seek an entire new management team to oversee the Motor Vessel division. Management has also decided that the new division should operate out of its own production facility. It can be built on the block of land adjacent to the current facility that HK already owns.

Senior management has decided that the appropriate planning horizon for the proposed new Motor Vessel division is 10 years. You work in the controller’s office of HK and have been asked to perform a series of analyses on this proposal. To facilitate your analysis, you have been provided with the Motor Vessel division’s projected income statements over the next 10 years, as well as the following information.

Capital expenditures

• The block of land on which the new production facility will be built was purchased by HK three years ago at a cost of $2.5 million. It has a current market value of $3 million, and it is expected that the value of the land will remain at $3 million when the project is complete.

• Management expects that the production facility will cost $10 million to build. It has an estimated useful life of 20 years and will be depreciated on a straight-line basis to an estimated salvage value of $1 million for accounting purposes. It belongs to an asset class with a CCA rate of 7.5%. At the end of the 10-year planning horizon, the facility will have an estimated market value of $3 million. The building qualifies for the Accelerated Investment Incentive, and 1.5 times the CCA can be taken in the year of acquisition. At the end of the planning horizon, assume that there is still a positive balance remaining in the class after the deduction of the proceeds.

• The new equipment required for the production of the HKMV55 will cost $7 million and has an estimated useful life of 10 years. For accounting purposes, this equipment will also be depreciated on a straight-line basis. It belongs to an asset class with a CCA rate of 10% and has an estimated salvage value of $500,000 at the end of its useful life. The equipment qualifies for the Accelerated Investment Incentive, and 1.5 times the CCA can be taken in the year of acquisition. At the end Corporate Finance Project Details 2 / 3 of the planning horizon, assume that there is still a positive balance remaining in the class after the deduction of the proceeds.

• The new Motor Vessel division requires an initial investment in net working capital of $750,000.

Operating revenues and expenses, and working capital accounts

• Data from the divisional pro forma operating income statements (see Appendix):

o Gross revenues are projected to be $12.5 million in the first three years of operation and $18 million from Year 4 onward.

o Cost of goods sold (COGS) is expected to be 56% of sales in the first three years and then decline to 50% of sales from Year 4 onward.

o The general and administrative costs are expected to be constant at $2.95 million per year over the 10-year planning horizon. Administrative costs include the allocation of senior management costs; the remainder of these costs relate directly to the new Motor Vessel division and are paid in cash when due.

• HK requires its customers to make a 15% deposit at the time of order and pay the balance at the time of delivery. The average lag between the time of order and delivery is two months. Sales occur uniformly throughout the year.

• HK has a policy of keeping a cash balance throughout the year equal to 2.5% of expected sales for the year, and an inventory balance throughout the year equal to 25% of expected COGS for the year. The cash balance is essentially funded by the required customer deposits and is invested in marketable securities at an average rate of 0.5%.

• HK’s suppliers currently offer terms of 1/10, net 60 on all purchases.

Capital structure

• HK’s capital structure consists of a single long-term debt issue with a face value of $20 million and 2 million common shares with a current market price of $15 per share.

• The long-term debt issue carries a coupon rate of 5% with interest paid semiannually. It has eight years remaining until maturity and a current market yield of 6%, also based on semi-annual compounding.

• The common shares have a beta of 1.15. HK paid a dividend of $0.95 per share in its most recently completed financial year. Analysts believe these dividends will grow at an average annual rate of 3% for the foreseeable future. The current risk-free interest rate is 2.5%, and the market price of risk is 6%.

• Recent discussions with HK’s investment banker have indicated that flotation costs would be 7% before tax on any new issue of common shares and 4% after tax on any new issue of long-term debt. Corporate Finance Project Details 3 / 3 General corporate information

• HK’s corporate tax rate is 32%.

• Senior management has determined that 12% is the appropriate discount rate to use in evaluating the proposal to expand its operations to motor vessels.

	Year 1 to 3	Year 4 to 10
Sales revenue	$12,500,000	$18,000,000
COGS	(7,000,000)	(9,000,000)
Gross profit	5,500,000	9,000,000
General and admin expenses	(2,950,000)	(2,950,000)
Depreciation	(1,000,000)	(1,000,000)
Operating income	1,450,000	4,950,000

Question 7

If a market is informationally efficient, should it respond to an announcement of HK’s intention to expand into the motor vessel market, and if so, how should it respond?

Question 8

The financial executive has three fundamental roles. Use the details of HK’s proposal to illustrate each of these three roles.

Question 9

The two primary alternatives to the NPV method for evaluating investment projects are the internal rate of return (IRR) method and the payback period (PBP) method.

a) Describe the IRR method and the PBP method.

b) Identify one advantage and one disadvantage each for the IRR method and the PBP method.

c) Which of the three capital budgeting methods — NPV, IRR, and PBP — is conceptually preferable? Explain why.

Answer 1

Question 9.

The calculation for PBP is:

Payback Period= Investment / Cash flow per period

The shorter the payback period, the favorable an investment of project is.

IRR uses a discount rate, which companies usually already identifies. The IRR equates the PV at the future cash flows with the initial investment.

a.) The calculation for PBP is:

Payback Period= Investment / Cash flow per period

The shorter the payback period, the favorable an investment of project is.

IRR method equates NPV to zero. IRR can be computed using MS Excel or manually by using the below formula:

IRR uses a discount rate, which companies usually already identifies. The IRR equates the PV at the future cash flows with the initial investment

0=Investment + Present Value - Future Cash Flow

The higher the IRR, the more favorable the investment is.

b.) Advantages and Disadvantages:

PBP: is much easier and simpler to calculate. No trial and error involved. It can be applied to various projects to help in decision making. However, it disregards the time value of money and only takes into account the how long investment will be recovered.

IRR: Trial and error is usually applied to get the IRR when computed manually. An advantage of this is that it can be computed using Excel. It takes to account the rate an investment or project grows. IRR is used together with NPV and WACC unlike PBP that can be used solely in computations.

c.) Generally, NPV is widely used by analysts as it takes into account the time value of money and is aided by IRR. Most financial analysts use NPV. PBP can be used simply as an added measure in analyzing project investments. NPV can be used to compare multiple projects.