Abstract This case study on project evaluation is applicable forbeginning courses in corporate finance or finance strategy. Twoalternative 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 tobe evaluated carefully and decision should be made on the basis ofthorough analysis of the data available using various capitalstructure and capital budgeting techniques. Keywords: Beta,Corporate Finance, Cost of Capital, Internal Rate of Return, NetPresent Value JEL Code: C10, G31, G32
Brooks Hamilton recently accepted a job with Tortuga FishingEquipment Company1 (Tortuga) in the company’s finance department.His first few assignments were fairly straightforward and Brooksrelied on his background in both accounting and finance to get hiscareer off to a great start. His manager, the company’s ChiefFinancial Officer (CFO) was impressed with his work and decided toput Brooks on a new assignment. The firm was embarking on a newproject which would define its future over the upcoming years.Given the importance of the project and high degree of visibilitywith the firm’s senior management, Brooks was flattered to be askedto assist and eager to show that he was up to the task. The financedepartment was tasked with preparing an analysis to make a decisionbetween two competing project plans which could very well decidethe future of Tortuga in the competitive fishing equipmentindustry. The Chief Executive Officer (CEO) wants to have an answerfrom finance and expects a thorough analysis very quickly.
Tortuga is an Islamorada, Florida based company specializing inmanufacturing high-end fishing rods and reels. Tortuga was foundedby a retired university professor who fished all of his life andwanted to create the best equipment possible to handle a variety offishing conditions and fish species. He partnered with an engineerwho ran a machine shop to produce some prototype reels and suppliedthese to commercial fishing captains as test market research. Theequipment produced by Tortuga was a significant improvement overthe current line available and orders were strong. Through theyears, the company made some modest improvements to their originalprototype and had become an industry leader. Tortuga’s products areused by tournament fishing teams around the world. Over the pastdecade, tournament fishing has grown to become a big business withcorporate endorsements and prize money. This growth has made whatwas once a recreational vocation into a full-time profession forsome anglers. The company recently launched an extensive researchand development effort focused on a new flyrod and reel designedfor one particular species of fish, the Atlantic Tarpon (Megalopsatlanticus). Tarpon are long-lived fishes that migrate in thewarmer climes of the Caribbean Sea, Gulf of Mexico, and along theAtlantic Ocean coastlines. Although the fish can reach lengths ofeight feet (~2.4 meters) and weights of 280 pounds (127 kilograms),they inhabit the shallow flats and exhibit acrobatic leaps whenhooked. These traits make tarpon a popular game fish for anglers.Fishing gear needs to be sturdy to handle the power of these fishand Tortuga had developed products for this niche market which wereallowing anglers to be successful in their angling pursuits.Recently, several sponsors had come together to launch competitiveangling events called tournaments, where the best anglers vie tocatch, and then release, the most and largest tarpon. Winners mayreceive up to $50,000 in a single weekend tournament and thedifference between winning and losing could be a few pounds. Withso much money at stake, tournament teams purchase the best gearavailable and are always looking for any competitive advantage withtheir equipment. Tortuga is looking to capitalize on this trend byoffering a new line called the Tortuga Tarpon Classic. This newline incorporates the latest material and design improvements andis predicted to be the “gold standard” for all serious tournamentsanglers. Tortuga plans to offer the Tortuga Tarpon Classic torecreational anglers as well to capture the growing demand byaffluent anglers who want the same high-quality gear as theprofessionals.
Tortuga began with a modest amount of capital that the founderhad managed to save during his years in academia. As the firm grew,its financing needs expanded as well. Through the years Tortuga haddeveloped and maintained a strong relationship with a large bankwhich provided short-term working capital funds in the form of arevolving line of credit. When a funding need arose, Tortuga woulddraw from this line of credit and then repay the short-term draw ascash flowed back to Tortuga. The $200 million revolving line ofcredit currently has $25 million drawn at an interest rate of3-month Libor plus 350 basis points2. The remaining $175 millioncredit line can be assumed to have no fees associated with it3.Brooks looks up the most recent 3- month U.S. dollar Libor rate andsees that it is 1.50%. Long-term financing was also in place in twoforms. After several years of revenue and earnings growth, Tortugaissued five million shares of common stock at an issue price of $10per share. The firm used this $50 million in funding to increaseproduction lines and build a global presence by opening anadditional manufacturing facility in Panama. Brooks finds thecurrent 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 interestsemi-annually and is currently trading in the market at 102.50 as apercent of par. The company has a 34% corporate tax rate. The firmcalculates its required return on equity with the Capital AssetPricing Model (CAPM) using a 4.0% historical Treasury rate for therisk-free rate and 6.0% as the historical market risk premium4.CAPM = Risk-free rate + beta (Market Risk Premium) The annual stockreturns versus the market are shown in Figure 1 below for the past10 years. Beta is calculated by regressing Tortuga stock returns onthe Standard & Poor’s (S&P) 500 returns. There are avariety of methods for calculating beta. Brooks could find beta byregressing five years of weekly Tortuga returns of the S&P 500.He could use five years of monthly returns or two years of weeklyreturns. Each of these is a valid sample period. One well-knowndata source provides an “adjusted” beta which is determined byfirst calculating a “raw” beta by regressing two years of weeklysecurity returns on the market. This is then adjusted by taking 2/3of the raw beta plus 1/3 of one. This adjusts the beta to be closerto one, since beta is not stationary and should naturally movetowards one through time as a firm expands. Brooks only has 10years of annual data available at the time and decides to conductthe analysis with this information to get a quick response. He willcheck his result with more data points before submitting his finalreport to the CFO.
Figure 1 Returns on Tortuga Stock versus the Standard & Poor500 Year Tortuga Return S&P 500 Return Year Tortuga ReturnS&P 500 Return 1 12 7 2 22 16 3 -2 -3 4 14 9 5 9 8 6 19 21 7 1617 8 -10 -5 9 7 9 10 12 14 Source: Author After Brooks calculatesbeta he employs formula (1) above along with the risk-free rate andmarket risk premium to determine the cost of equity. The firm’sweighted average cost of capital is a function of its equity marketcapitalization, cost of equity, short- and long-term debt amountsand costs, and the tax rate. Using formula (2) below, Brooks canfind 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 taxrate 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 ownerswill need to calculate beta Rm= equity risk premium Tortuga TarponClassic The company has two separate research teams working on theproject and they develop two distinctly different fishingcombinations. The two rod and reel combinations are test marketedwith guides and past tournament champions and demand forecasts aredetermined. Most fishing gear has a relatively short life due tocontinual product innovation. Manufacturing of the two combinationsis estimated to require an upfront cost of $5 million to retool themachine shop. The process for manufacturing the two combinationsdiffer and ongoing variable costs are not the same. The net cashflows for the entire ten year expected life of the product is shownin Table 2 as Project A and Project B (all figures are $thousandsof net cash flow). Project A focuses on hand tooled fishingequipment which results in a more labor intensive process, but alsoallows for personalized features for customers. The price chargedfor customization offset the slower hand tooling process togenerate substantial net cash flows. Part of the upfront $5 millionincludes the costs of training more machinists in the art of handtooling, which is similar to watch making but with a few lessmoving parts. Project A is anticipated to generate lower cash flowsin the early years due to the length of time required to getmachinists who are adept at hand tooling to customerspecifications. In fact, during the first year there will becontinued expenses to attain these skills which causes year one netcash flows to be negative. Over time the cash flows increase asmore machinists gain proficiency. The project is expected toexperience lower cash flows towards the end of its life due tomarket saturation. Due to the quality of the reels, they are builtto last and seldom fail or wear out. Technological obsolescence iscertain although Tortuga will be investing cash flows into researchand development to launch the next generation at the conclusion ofthe Tortuga Tarpon Classic life cycle. Project B employs amechanized approach to large scale production of standardizedequipment. Although the approach does not allow forpersonalization, it does allow Tortuga to build its inventoryquickly and capture positive net cash flows immediately. Theupfront expense is almost completely devoted to tooling equipmentprocurement and the number of units produced will be much higherand at lower price points than the approach of Project A. At theend of both projects life it is assumed that there will be zerosalvage value as the pace of innovation will require a completere-tooling for the next generation and the useful life of theequipment will have been fully realized. Brooks realizes that hewill need to calculate the firm’s cost of capital discount rate andapply this to the cash flow projections of both projects. Herecalls all of the assignments he completed at university and isthankful to have been so well-prepared for this task. He gets a cupof coffee, sits down at his desk, and gets to work. Figure 2Project Net Cash Flows for Tortuga Fishing Equipment ($thousands)Year Project A Project B 1 -900 950 2 200 950 3 900 950 4 1800 9505 2500 950 6 2500 950 7 1800 950 8 1200 950 9 800 950 10 200 950Source: Author Since Brooks is new to his role, you have been askedto review his work and assess the financial viability of theprojects. Given the importance of this decision you are helping tomake sure the firm makes the right choice. Notes: 1. Fictitiouscompany created to illustrate corporate finance principles. 2.Libor is an acronym for London Interbank Offered Bank, which is astandard floating interest rate benchmark for credit facilities. Abasis point is equal to 1/100th of 1%. One percent is 100 basispoints. 3. Typically a bank will charge a facility fee for theentire credit facility, $200 million in this case and an interestrate based on utilization. We assume no facility fee forsimplicity. 4. The risk-free rate is determined based on thegeometric average of the long-term Treasury. The market riskpremium is calculated based on the difference between the geometricreturn on the Standard & Poor’s 500 index and the long-termTreasury.
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 thecapital structure? (Rd & Re) 3. Using the information provided,what is the firm’s weighted average cost of capital (WACC)? 4. Whatare the net present value (NPV), internal rate of return (IRR), andPayback Periods for Projects A & B? 5. What decision rules willyou use to help Tortuga reach a decision? 6. What are the strengthsand weaknesses of each of the evaluation tools?
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