Case:
Background
Jim was excited as he drove into the car park at Floating Investments Limited. The senior management meeting was scheduled for 9 AM and his proposal was the major item on the agenda. Jim's o?cial title was Projects Manager and he was responsible for initiating and overseeing new projects. This particular project was close to Jim's heart because it involved sailing"an activity that Jim had spent many years pursuing both socially and competitively. Jim believed that his project was well suited to Floating Investments as it was an extension of existing business.
Floating Investments Limited specializes in marine investment projects. Projects previously undertaken by the company include construction of canals and moorings for a major residential development and redevelopment of 'Fisherman's Wharf' in the downtown area. Given the nature of these projects, including the length of time over which the initial investments were recovered, the degree of risk involved was generally higher than more traditional investment projects.
Although Jim had completed a business degree at University, he was determined that his accounting background would not overshadow his career choice as an operational manager. Last night he had told his wife: "This project sells itself. The idea is good. I know the sailing world and we've got the big picture sorted out. Newland Harbor has only one marina to serve over 6000 boats, 80% of which cannot get marina berths and use moorings that sailors must row to. We've already got the site and the contractor lined up to build a new marina. All we need is management's go ahead. The accountants can sort out the dollars and cents later."
The Chief Executive O?cer (CEO) opened the meeting and after the preliminaries gave Jim the signal to present his proposal. Jim knew the CEO was an experienced yachtsman and was con?dent that he would support the project. He started his proposal by describing the current shortage of marina berths and the size of the market, emphasizing that the local Port Authority owned the only existing marina. Because the Authority charged only a minimal rental, anyone who possessed a berth generally kept it and there was an elaborate (and lucrative) black market in trading the license to those on the waiting list.
Jim continued, "The proposed marina is designed for 500 boats and we estimate that it will take two years to build commencing 1 November 2001. Because of the shortage of marina berths it is expected that all berths will be leased from 1 November 2003. The 50-acre site we intend using for the project was purchased several years ago for $268,000 as part of the Fisherman's Wharf development, although it was never used for that project.
Construction of the marina falls into three stages:
1. Construction of sea walls, dredging the seabed, excavations for marina o?ces and service facilities, and road access.
2. Inserting piles and assembling pontoons.
3. Constructing buildings and facilities such as marina o?ce, chandlery, repair workshops, and waste disposal.
The most favorable tender, from a reputable construction company, indicates a total construction cost of $12,000,000 payable as follows:
10% payable prior to commencement (31 October 2001)
40% payable one year later
40% payable on completion (31 October 2003)
10% retention payable one year after completion
There will be three categories of berths:
Category A for boats between 12 and 18 meters in length: 50 berths
Category B for boats between 8 and 12 meters in length: 300 berths
Category C for boats between 6 and 8 meters in length: 150 berths
I am sure you will agree that this is an excellent project and an exciting opportuA?nity for the company."
Jim sat down. The CEO spoke: "That site you had in mind. We've just had an o?er from a real estate developer of $7000 per acre. How does that a?ect your project?" Peter Shrivers from marketing also asked: "How much are you going to charge for the berths? I know that the Port Authority charges $4500 for my 10-meter ketch. How does this compare? And what is the bottom line on this?"
Jim was silent. He hadn't thought that management would want the ?nancial details so soon. Help came from an unexpected quarter. Emma Nautically, the Financial Controller spoke: ''Figuring out a price is not going to be easy because there has not been a proper market for marina berths in Newland before. A sensible ?rst step would be to calculate the minimum rental for the project to break even. At the same time we can commission a market survey to ?nd out what price boat owners will be prepared to pay for the berths. We also need to consider other issues such as tax e?ects, in?ation, and the opportunity cost of funds. Why don't Jim and I sit down and sort out a formal ?nancial analysis and present it at the next manageA?ment meeting this time next month?''
To Jim's great relief, the meeting agreed to Emma's suggestion. He was o? the hook, at least for the moment. After the meeting had ended, he thanked Emma. She laughed: "It always pays to buy some time particularly when it's a big project. You had the big picture okay but at the end of the day, the ?nancials have got to be sorted out. I know you majored in management accounting at University so you can probably remember how to do this type of analysis. Let me give you some further information." Jim started taking notes.
Emma continued: "The tax rate is 50% and 4% depreciation on a straight-line basis will be allowed for 80% of the construction cost. The company's cost of capital is 16.6% after allowing for tax and in?ation. Based on current needs and past experience, 16.6% should cover the required rate of return to shareholders, debt repayment, and include a factor for the risk involved in this type of investment. Let's assume that cash ?ows take place at the end of each year. What about operating costs and working capital?"
Jim replied: "I estimated that the lease rentals, maintenance and supervisory costs and land values will rise in line with in?ation, which is expected to be 6% annually over the life of the marina. Annual maintenance and supervisory costs are estimated to be $60,000 at current prices. Working capital requirements are not expected to be signi?cant."
Emma asked: "What will the time horizon be? We will need to think about termA?inal values as they can often determine the success or otherwise of a project."
Jim considered her question: "We intend that the lease periods for each berth will be for a twenty-year period; in other words, the period from 1 November 2003 to 31 October 2023. It's probably safest to assume initially that the land will be the only valuable asset at the end of 2023."
Emma gave Jim's reply some thought and then said, "Okay, I think that we have enough information now to do the analysis. There are two things we need to do. First, we have to calculate the amount of annual, pre-tax lease rental that must be generated in order for the project to break even. Calculate this amount for the ?rst year of operations."
"Second, using this ?rst-year amount, calculate how much an owner of a 10-metre yacht will pay in the ?rst year. We can then compare this with the amount Peter Shrivers pays. I guess a simple way of doing this is to use the mid-points of the size ranges to calculate the total meters."
Jim returned home that evening. "How did it go?" asked his wife. Jim confessed: "I think I would have been out of a job if it hadn't been for the accountants. Have you seen my old management accounting books? I'm going to need them."
Required:
Identify the information that Jim needs to present to the Board at the next meeting, providing calculations using the data supplied. Set out all the assumptions that need to be made and examine their reasonableness and consequences if violated.
Include in your information set an analysis of the risks inherent in this type of investment and discuss the ways in which management of these risk factors can be incorporated in the project.