Case Study: Wankirn and Sons, Inc.
Wankirn and Sons, Inc., founded in 2010 as a sole proprietorshipthat later incorporated and went public with its initial public offering (IPO) in 2012, is a company that has done very well in the manufacture of electronic interfacedgizmos, especially over the last 3 yearsor so (2014-2017) as the economy has improved. The Chief Executive Officer (CEO), DeborahWankirn, has developed a management team comprised of herChief Financial Officer (CFO), Marshall Moneybags; the Chief Operating Officer (C00), NancyGetitdone; the Vice President of Sales and Marketing, Sam Showmen; the Vice President of Manufacturing, Mickey Madehere; the Facilities and Maintenance Director, Lefty Rench; and her Vice President of Human Resources, Penelope Peopleskills. Wankirn is very proud of the company'ssuccess in the recent past and credits her management team for the positive performance results.She considers them to be one of the best management groups in the industry. They don't always agree on issues, but they do find ways to resolve differences and move forward constructively.
The CEO has identified a new product that is different from the array of electronic interfaced gizmos they have been manufacturing and selling for the past three to four years, and wants to finish prototyping it in order to get it into production quickly, and to market. She thinks this new gizmo will create a competitive advantage in the industry (Wankirn and Sons ranks second in a number of important financial ratios and other performance factors, when compared to the top-ranked companies in the industry) for several years to come, and believes this product line may even vault them into the lead in their industry. She has proposed a capital budget for the project of approximately $2.9 million consisting of new machinery and associated costs, as follows: new machine purchase price is $2.65 million;installation costs of $132,000;freight of $61,000;$37,000 for retooling the new machine; and $28,000 for a product market study that was completed approximately two years earlier. She also believes that she has most of the right people, and training will ensure that they are capable, although she may have to add some new people with specialized skills in the near future.
This is the largest single investment that the company has made in many years. A number of team members are privately expressing concern about the risks associated with a project this size, the commitment it would require of key staff, and have quietly suggested (among themselves) that they should develop several smaller projects instead of one so large. The debate is about to become public, as Wankirn has called a team meeting to discuss the issues.
In addition, she and her team have had several discussions about how to evaluate the project, with several team members recommending one form or another of the payback method, another team member suggested the use of internal rate of return (IRR), and two other members recommending the use of net present value analysis (NPV). Wankirn wants to reach agreement on the project first, and then decide how to evaluate it. The others want to make sure the evaluation technique choice is made first, and have stated that the chosen technique should be appropriate for any project they undertake, not just this one.
If they are to use discounted payback, the IRR or NPV methods, they face another decision: That is, estimating the cost of capital at which to discount the future cash flows, and/or use as a basis for comparing project IRR's. In the discussion, the weighted average cost of capital (WACC) was mentioned as was the cost of debt, since the project most likely will be financed using primarily debt and probably some excess cash they have in short term investments. The current cost of debt is 8.1%, but they will have to determine whether this project is riskier than other projects they have funded in the past, considering that the overall beta for the firm is 1.1. Their initial estimate of beta for the project is 1.35. They have researched the risk free rate (rRF) and determined it to be 3.0%, while the risk premium for the market (RPM) is estimated to be 4.85%. The corporate, state, and local combined tax rate is 40%. The company's current market debt and equity proportions are 60% and 40%, respectively, and this ratio is to be maintained as much as possible as their target capital structure.
In the process of gathering information to bring to the next team meeting, several members offered what they thought were additional pertinent facts and figures related to the project: The VP of Manufacturing stated that the useful life of the new machine is projected to be 6or 7 years, and no salvage value could be estimated at this time, although he indicated that since it was a very specialized piece of equipment it would have little or no value to others; the CFO reminded everyone to use the modified accelerated cost recovery system (MACRS) and that the most appropriate class life was probably five years (20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%);and the Facilities and Maintenance Director estimated the maintenance costs to be $49,000 per year, which he also stated should remain steady over the project's life.
The CFO and the VP of sales and marketing had been working together for the past several weeks outlining some revenue and cost projections that they might use in the analysis. They estimated that revenues are expected to increase (in other words, incremental revenues) by the following amounts for each year of the project:
Year 1 (2018) $1,260,000
Year 2 $1,479,000
Year 3 $1,793,000
Year 4 $2,198,000
Year 5 $2,704,000
Year 6 $3,230,000
The estimated incremental annual operating costs (excluding depreciation and maintenance), areprojectedto be 61% of revenues, and current accounts are expected to increase as well during the project life. The most notable of the current accounts to be considered are the working capital accounts. Specifically the inventory and other current asset accounts will increase by $121,000, and accounts payable will increase by $26,000.
As they pull together the information that will be required to make the important decisions they are facing, several team members wonder if they have all of the information that is needed. Several members want best and worst case scenarios included in the analysis; others suggest that a sensitivity analysis be developed and completed, especially since the estimates for the later years of the project are just "best guesses" at this time. At the last minute, they realize they may need some help in facilitating the analysis, and the CFO has recommended that you (a trusted former employee who went back to school to obtain an MBA degree, and have since joined a small consulting firm) be contacted to help them through this process. You have agreed and you now have access to all of the information that they have. In addition, you have specialized knowledge concerning capital budgeting and investment decision-making.
Furthermore, several questions have been developed by the CEO andthe team to help guide your facilitation process, and the questions are listed below. However, there may be other issues that they have not considered and that they want you to identify and address - keep these in mind.
Questions:
1. a. What capital budgeting evaluation or analytical technique is the most appropriate one to use,and why?
b. Should more than one technique be used? Discuss and explain.
2. If mostly debt(but not all debt) is used to finance the purchase, should the cost of debt be used as thecost of capital,or should the WACCor some other discount rate be used? Explain and justify your answer.
3. a. There is some debate about the costs that should be considered in the computation of total initial outlay. Please indicate those appropriate costs to be included by itemizing(listing by name) them, and also discussany that should not be included and explain why.
b. Based on your answer to Question 3 above, what are the total cash outlays to be incurred at the beginning of the project (time zero on the time line)?
4. Next, calculate the annual operating cash flows for years 1 through 6, ensuring that you include all pertinent revenues and expenses. Remember to compute depreciation using MACRS, and that you use the appropriate depreciable base cost for the equipment. Please itemize these so that all members of the team will be able to review them, line by line. And remember any final (terminal) year calculations that may be appropriate (salvage value, taxes, return of net working capital, etc.)
5. As a result of your discussion in question 2 above, identify and calculate the appropriate cost of capital (discount rate) that should be used in a net present value analysis, or as the basis forcomparison when using the IRR approach. Then use this discount rate to complete your NPV analysis (calculate the NPV), or to compare against the project's calculated IRR if you chose that method.
6. Using the results of your NPV or IRR analysis, what is your recommendation to the CEO and her team regarding the project? Are there any other factors that should be considered, such as any issues the team members noted? Explain(hints: scale and the possible use of hurdle rates).
Attachment:- Case Study-Gilbert Enterprises.rar