|Case 9 | |Performance Boating Products, Inc. | Performance Boating Products, Inc I. Situation Analysis • Performance Boating Products, Inc (PBP) manufactures attachments for boat hulls and motors that aid watercraft in reducing drag and maintaining ‘plane’. • PBP attachments can be integrated as part of new boats or retrofitted to older boats and motors. PBP’s primary installion base includes clients wanting an extra degree of performance from their boats and boat manufacturers offering PBP products as options. • The PBP executive team has been working for the last few months to put together a plan for expansion projects to increase future revenue flow • A brief summary of the three individual projects can be viewed in the table below: Melville |Broadside |Turbine | |Project Plan: |Project Plan: |Project Plan: | |Construction of new warehouse in a |Construction of new production facility |New apparatus development | |strategic geographic location | | | | |Potential Benefits: |Potential Benefits: | |Potential Benefits: |Increase production to alleviate backlog|Increase future revenues | |Increase sales in the selected |of orders |Expand existing product lines | |geographic region | | | |Reduce distribution costs | | | SWOT Analysis Strengths |Weakness | | | | |Able to command high prices in the market |Products easily replicable | |Design protected by copyright |Inefficient functional managers | |High profit margin due to high markup |Limited production Capacity | |Cheap raw materials (metal and fiberglass) | | |Demand exceeded production | | |Flexible design that can be adapted to existing boats or | | |could be integrated with new boats | | |Opportunities |Threats | | | | |Expansion opportunity present |Development of competition | |New Product Development |Designs can be easily duplicated with minor changes | |Enlarge Production Capabilities |Market will mature and reduction in profit margins | |Restructure corporate environment | | All three projects have the same amount of risk associated with them and they are not mutually exclusive. • All the projects under consideration are fairly large and hence had to be reviewed with great accuracy and detail before one of them is to be selected. II. PBP’s Approach to the Problem Calculating the Cost of Equity Sam Cutlowe was in charge of evaluating the three asset expansion projects under consideration and reporting his recommendations back to the company’s CEO Mr. Goodson. The first step for Sam was to calculate the firms cost of capital. To do so, he used three different methods: the Discounted Cash Flow (DCF) method, the Capital Asset Pricing Model (CAPM), and the Bond Yield + Risk Premium (BY + RP) method.
All three of these methods can be used by companies to estimate the attractiveness of an investment opportunity; however, each separate model contains its own specific strengths and weaknesses. For this reason, all three will be discussed in detail, and the strengths and weaknesses of each method will be touched upon. The DCF Method The DCF method uses future free cash flow projections as the basis for determining whether to invest in a particular project or not. The cash flows are either dividends paid by companies that have already gone public, and who are viewed as a going-concern, or are dividends for some number of years plus a terminal price when a firm is expected to be acquired or liquidated (therefore not necessarily a going-concern).
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The future cash flows are discounted back to present value (PV), the dividends in future years are divided by the PV, and the expected growth rate is added to that number to arrive at the required rate of return that should be earned on retained earnings to justify whether putting earnings back into the business rather than paying them out as dividends is a good idea. The formula described above is written as: ^ rs = r = D1/P0 + Expected g The DCF model of course has both strengths and weaknesses. A strength of the model is that it is a very simple model to use. If a company can confidently determine its future dividends as well as determine its expected growth rate, the required rate of return can easily be calculated. As well, free cash flows, the variables used in the DCF method, are rather reliable numbers. They help decrease the amount of guessing and speculating involved in reported earnings.
However, there are also weaknesses to the DCF method. First off, it is very easy to calculate the Dividend Yield, D1/P0, however, because stock prices fluctuate, the yield varies from day to day. This in turn leads to fluctuations in the cost of capital calculated under the DCF method. Furthermore, determining the expected growth rate is difficult to complete. It is possible to use a growth rate based on the company’s history if earnings and dividends have been stable. But, if growth rates in the past have varied for any number of reasons, the historical growth rates should not be used in calculating the cost of capital; rather, an average of expected growth rates should be used.
The required rate of return can also be tainted if the company does not have a high degree of confidence in future cash flows. Improperly estimating future dividends will throw the entire equation off. Another weakness of the DCF method is that it is not well-suited for short term investment opportunities. The DCF method focuses more sharply on long term investment opportunities. This means that jumps in the company’s value in the short term may not be taken into consideration. For this reason, if a company uses the DCF method to determine cost of capital, the company being valued should be watched on a day-to-day basis, and the return should be calculated often. Below is listed the cost of capital results that Sam calculated under the DCF method:
The Marginal Cost of Capital under the DCF method [pic] Figure 1 The CAPM Method The Capital Asset Pricing Model (CAPM) is another method that companies can use to determine their cost of capital. CAPM is actually the most widely used method for estimating the cost of capital. It is best represented by the formula: r = rf + ( ? ? (rm – rf)) where r is the expected return of a capital asset rf is the risk free rate rm is the expected return on the market and ? is the beta of the cash flows or security being valued In regards to using CAPM to determine the cost of capital, there are a few strengths and weaknesses that need to be noted. Some of its strengths include the following.
First off, the risk premium that is used within the formula (rm-rf) is adjusted to reflect the overall riskiness of the asset as it relates to the market. This is going to make cost of capital results more accurate as they relate to current market conditions. Further, CAPM attempts to more accurately quantify the risk-reward tradeoff by associating observed variables when defining the risk premium and the beta coefficient. Again, the strength here is that by relating the RPm to the market, companies are going to be able to more accurately determine the risk associated with an investment. The risk of an asset will be more accurately defined and CAPM eliminates some of the subjectivity that is used with other methods used to calculate the cost of capital.
There are several weaknesses to using CAPM as well. Number one, if the firm’s stockholders are not well diversified, they will be concerned more with the company’s stand alone risk than its market risk. If this is the case, then the firm’s actual investment risk would not be measured by its beta thus resulting in an underestimate of the investment risk. Another weakness with the CAPM approach is that it is difficult to determine and obtain accurate measurements for the required model inputs. It is difficult to obtain the measurements for three reasons. First, there is much controversy surrounding the idea of whether or not a company should use the ong-term or short-term Treasury yield for rf, second, estimating the future beta is also difficult to do, and third, measuring the correct market risk premium is also difficult to do. Below are listed the costs of capital determined by Sam under the CAPM method: The Marginal Cost of Capital using CAPM [pic] Figure 2 The BY+RP Method The Bond-Yield plus Risk-Premium (BY + RP) approach is a subjective procedure used to estimate the cost of capital when the inputs for CAPM are not available and when the DCF method is not used. The basic premise behind this model is that the interest rate on the company’s own long term debt is added to a predetermined risk premium on a firm’s stock to determine the required cost of capital.
The risk premium on a firm’s stock over its own bonds generally ranges from 3 to 5 percent. The formula for this approach is as follows: rs = Bond yield + Risk premium Obviously, firms with riskier, lower-rated, and higher interest debt are going to have a higher cost of capital than is a less risky company. As has been the case with the other two models, there are also strengths and weaknesses with this model. Regarding strengths, the BY + RP method is very simple, and there are a limited number of assumptions used with the model. All it requires is that an estimated RPm be added to the company’s bond yield to arrive at the cost of capital.
Further, the model most likely will not produce an exact cost of capital; however, it will most definitely put the company in the right ballpark because empirical studies have shown that the RPm on a firm’s stock over its bonds generally does range from 3 to 5 percent. For this reason, the cost of capital will be a descent estimate, but it will not be exact. This in fact can be described as one of the weaknesses behind the model as well. It will be very rare to estimate the exact cost of capital while using the BY + RP method because the company has the decision to use a risk premium ranging from 3 to 5 percent. Guessing it head on would be near impossible. Another weakness is that there is truly no theoretical justification behind the model.
Because of this, it would appear that using the BY + RP method to calculate the cost of capital would be foolish; however, there does appear to be some observed soundness behind the notion that a return on a company can be estimated by adding a fixed risk premium to its YTM. Below you will find Sam’s calculations of the cost of capital while using the BY+RP method: The Marginal Cost of Capital using BY+RP is shown below in Figure 3[pic] Figure 3 Conclusion In conclusion, each of the three cost of capital methods discussed above (DCF, CAPM, and BY+RP) may be used by firms. On the one hand, it would be wise to calculate the cost of capital under all three of them if the information is available. However, if management feels more confident about one method over the others, then the company will probably use that method.
However, an option that management should consider is averaging the three methods’ results together. Weights could also be given to the different methods, and from there the weighted average could be calculated. Regardless of the method used, it is very important to use judgment when determining the cost of capital. Sam Cutlowe determined the cost of capital for the three different projects under each of the three methods. Within the specific initial cost ranges of the three projects, Sam found that the DCF method gave him the lowest cost of capital at 14. 63%, the BY+RP approach computed the second highest cost of capital at 14. 98%, and lastly, CAPM gave him the highest cost of capital at 15. 14%.
When we calculated the NPV, we decided that our most accurate results would be calculated if we averaged the rates calculated by Sam under each method in order to determine the WACC used in the formula. Therefore, based on the pre-determined initial costs of each project, and the cost of capital that correlates directly with each initial cost range, we determined the WACC as follows: Melville Broadside Turbine 14. 63+15. 14+14. 98/3 14. 63+15. 14+14. 98/3 15. 05+15. 14+14. 98/3 WACC = 14. 92%14. 92% 15. 06% Calculating the IRR To aid his decision, Sam decided to calculate the Internal Rate of Return (IRR) for each of the three projects under consideration.
To do so, the incremental net cash flows for each of the three projects first needs to be calculated. The incremental cash flows are calculated as: |Annual Sales | |-Oper. Costs | |-Depreciation | |EBIT | |-Tax(40%) | |Net Income | |+Depreciation | |Cash Flow | A full statement of the incremental cash flows for each project can be found in the attached spreadsheets. Taxes are estimated to be 40% and the facilities required for the projects are depreciated using the MACRS 15 year depreciation schedule. With the incremental cash flows, we were able to calculate the internal rate of return using Microsoft Excel. The results were: |IRR |Payback Period | |Melville |16. 71% |5. 78 | |Broadside |17. 36% |5. 58 | |Turbine |15. 57% |6. 14 | Investment Opportunity Schedule The investment opportunity schedule is: a) A determination of the weighted average cost of capital at various increments of financing. b) A list of investment opportunities available to the firm. c) An internal rate of return ranking of capital projects from best to worst. d) A set of decision criteria for determining the acceptability of capital projects.
To create an investment opportunity schedule, we will overlay these results against the cost of equity graphs we created earlier. Projects with the highest IRR will be given priority in our decision making. Discounted Cash Flows [pic] CAPM [pic] BY + RP [pic] Regardless of which method we use to calculate the cost of equity, Performance Boating Products, Inc. should choose to invest in the Broadside and Melville projects since they have an IRR greater than the cost of capital. The Turbine project should be rejected as it will not produce a high enough return to cover the cost of capital. III. Issue With PBP’s Approach One major flaw in Sam Cutlowe’s analysis was his use of IRR to determine whether to accept the three projects.
The Internal Rate of Return has two major shortcomings. First, IRR may produce two different results if the project has non-normal cash flows. Non-normal cash flows occur when a cash outflow takes place after the first cash inflow. Secondly, IRR assumes that cash flows can be reinvested at the same rate. It is typically difficult to continue finding new projects that can provide the same IRR as your original project. While the first shortcoming is not an issue for PBP as all of the projects have normal cash flows, the second issue is a problem for the company. A better approach for PBP to follow would be to evaluate their projects using the Modified Internal Rate of Return (MIRR).
MIRR assumes that cash flows are reinvested at the weighted average cost of capital and thus provides a better measure of profitability. It provides a better estimation of the true rate of return than IRR. To determine the MIRR, we must first estimate PBP’s weighted average cost of capital. We determined this by taking the average of the marginal cost of capital in the three methods we discussed earlier. This leads to WACC as follows: • Melville – (14. 98%+15. 14%+14. 63%)/3=14. 92% • Broadside – (14. 98%+15. 14%+14. 63%)/3=14. 92% • Turbine – (15. 05%+15. 14%+14. 98%)/3=15. 06% Using Microsoft Excel, we can then calculate the MIRR by using the =MIRR function.
This function requires our incremental cash flows and the finance rate (WACC) and the reinvestment rate (WACC). Using this formula we obtain the following results: | |MIRR |IRR | |Melville |15. 32% |16. 71% | |Broadside |15. 45% |17. 36% | |Turbine |15. 18% |15. 57% | For comparison, we have also listed the IRR results from above. It is clear that the MIRR can affect our decision to accept or reject a project. Luckily for Sam, the accept or reject decisions from above are still valid. This can be seen in the graphs below. BY+RP MIRR [pic] Discounted Cash Flow MIRR [pic] CAPM MIRR [pic]
The results calculated by using MIRR are the same as the results when using IRR, and that is to reject the Turbine project, but accept the Broadside and Melville projects. There are other ways Sam could evaluate the projects as well. The first method is to calculate the payback period. This is the number of years of cash flows required to pay back an investment. We did include these results in our table containing the internal rates or return. Overall however, this is not a preferred method as it ignores any benefits beyond the initial payback period. It is popular in the hospitality industry because that industry has a widely accepted standard to measure the payback period against.
Additionally, Sam could have used Net Present Value to compare the projects. We can calculate the NPV using the weighted average of the results of three MCC calculation methods. If the company chooses to invest in only one project then Broadside would be the best single investment. The discount rate used and the NPV results would be: |? |Discount Rate |NPV | |Melville |0. 149166667 |$960,288 | |Broadside |0. 149166667 |$1,196,742 | |Turbine |0. 150566667 |$446,659 | If the company chooses to invest in a combination of two projects, the discount rate used and the NPV would be: |? Discount Rate |NPV | |Melville & Broadside |0. 150566667 |$1,995,096 | |Broadside & Turbine |0. 150566667 |$1,564,533 | |Turbine & Melville |0. 150566667 |$1,323,881 | If the company chooses to invest in all the projects, the NPV and the discount rate would be: |? |Discount Rate |NPV | |Melville & Broadside & Turbine |0. 1655 |-339493 |
Thus, we can see that if the company chooses to invest in all three projects, there will be a negative NPV. The combination of Melville & Broadside generates the highest NPV which is 1,995,096. Therefore, the company should choose to invest in both Melville and Broadside but not Turbine. IV. Evaluation Against Industry Peers One final comparison we used was to evaluate how the three projects would have fared had they been proposed at a true company. To perform this comparison, we chose two of the largest companies in the consumer boating industry. Brunswick Corporation (http://www. brunswick. com) is the owner of many different brands including Bayliner and Mercury Marine.
Marine Products Corporation (http://www. marineproductscorp. com) is one of the top three manufacturers of sterndrive powerboats in the United States. Both are traded on the New York Stock Exchange and list their annual reports on their websites. To find the MIRR of the Melville, Broadside and Turbine projects we need to find the WACC of these two companies. This requires that we find the cost of debt and the cost of equity for both companies. This information needed can be found in the company’s annual report or on a stock reporting website such as http://finance. yahoo. com. All calculations are based on the fiscal year 2009. Cost of Debt and Effective Tax Rate
Looking at Brunswick Corporation, we can find information in their annual report to estimate their annual tax rate. By taking the difference of the income before taxes and the income after taxes, and then dividing that by the income before taxes, we estimate that Brunswick Corporation had a tax rate of 14. 39% in 2009. |Brunswick Corp |2009 (In Millions) | |Income Before Taxes |-684. 7 | |Income After Taxes |-586. 2 | |Effective Tax Rate |14. 39% |
Dividing Brunswick Corporations interest expenses in 2009 by their total debt (long term plus short term) gives us a cost of debt of 10. 12%. |Total Debt (Short Term + Long Term) |850. 9 | |Interest Expense |86. 1 | |Cost of Debt |10. 12% | Cost of Equity The current beta of Brunswick Corporation is 3. 31. We estimate the risk free rate to be 4% (approximately close to the current 30 year t-bill rate) and the market risk premium to be 8% (an estimate).
Then Cost of Equity= 4%+3. 31*(8%-4%)=17% WACC Using a market capitalization of 1. 5 billion and a total firm value of 2. 3509 billion, we then have all of the components needed to calculate the WACC. WACC=(1-14. 39%)*(850. 9/2350. 9)*10. 12%+17%*(1500/2350. 9)=14. 14% Similar calculations carried out against Marine Products Corporation give us a WACC of 8. 84%. This low WACC may be influenced because the company carries no debt. All numbers used in the calculations can be found in the attached spreadsheets. Summarizing the results, we find: | |Brunswick |Marine Products | |WACC |14. 4% |8. 84% | |MIRR Melville |14. 72% |10. 82% | |MIRR Broadside |14. 86% |10. 95% | |MIRR Turbine |14. 49% |10. 66% | All three projects have a return above the WACC for both Brunswick Corporation and MPC. If any of the projects were under consideration individually, they would likely be accepted. Since the projects are not mutually exclusive however, we cannot determine whether all three projects would be accepted without seeing the full marginal cost of capital schedule.
Other factors may influence these numbers including our estimations of the market risk premium, Marine Product Corporation’s cost of debt which may be required to fund these projects, and other changes to the economy which may have taken place in the time period between PBP’s consideration of the projects and the year 2009 (when we made our calculations for Brunswick Corp. and MPC). References http://www. brunswick. com http://www. marineproductscorp. com http://finance. yahoo. com http://findarticles. com/p/articles/mi_m0OOL/is_3_5/ai_n6272119/pg_2/? tag=content;col1 http://www. investopedia. com/university/dcf/dcf5. asp Cases in Financial Management (Case Book) Fundamentals of Financial Management (Text Book)