PLEASURE CRAFT INC. CASE ANALYSIS Case Solution
Pleasure Craft Incorporation (PC), the manufacturer of personal watercraft and snowmobiles is seeking to expand its business. The sales of the products within the two business segments of the company have reached its maturity stage. Both of these segments were not offering the company with strong potential for growth in the future years. Therefore, in order to sustain the growth of the company, the management was considering investing in two options.
The first option was to invest in the business of front end loaders which would be sold to ranchers, farmers, construction companies and military and municipal. The second option was to manufacture outboard motors. Nancy Cummins was assigned to analyze both of these projects along with her team by determining the future cash flows, costs of capital and the initial cash flows for both the projects. We would be analyzing this case by taking the position of an independent consultant and then make a final recommendation to PC management based on a number of quantitative and qualitative factors.
Evaluation of the Projects
The evaluation of both the projects would be performed on the basis of the qualitative and the quantitative factors. The initial costs, annual cash flows and the cost of capital for both the projects would be computed and then the net present value and the internal rate of return for both the projects would be calculated. Apart from this, the availability of the financing options would be evaluated for both the projects independently and then a final recommendation would be made to the management of PC.
Front End Loader Project
The first project which would be evaluated in this report is the Front End Loader Project. This is the first option available to the management of the company. The company could manufacture small front end loaders which could be then sold to the ranches, farmers, construction companies, the military and the municipal governments. The main challenge for the company under this project was that the management of PC will have to made sales in a market where the company had zero sales experience. Therefore, in order to make this project successful a sales team will need to be developed and sales managers, regional managers and other sales people will also need to be hired.
Annual Cash Flows
The annual cash flows for this project have been calculated as shown in the excel spreadsheet. This project would have a total life of 15 years after which the management of PC would consider its options related to the product line. In computing the annual cash flows, the initial purchases of the land, equipment and the building would take place in year 0. The net investment has been converted into the gross investment using the formula:
Initial Investment/ (1-Weighted Average Floatation Costs)
The weighted average floatation costs for the overall company have been computed on the basis of the target capital structure of 30% debt and 70% equity of the company. The costs of issuing new equity and debt are 8% and 3% respectively. This gives us a weighted average of the flotation costs of 6.5%. The calculations could be seen in the excel spreadsheet. Finally, all the other calculations for the net cash flows of the project including the salvage values in year 15 could be also seen in the excel spreadsheet.
Weighted Average Cost of Capital
The front end loader business segment represents a riskier business for PC because construction is considered more cyclical as compared to recreational vehicles. Moreover, this business segment was also subject to intense foreign competition due to low wage emerging economies such as China. Therefore, the company’s current cost of capital would not reflect this risk. In order to calculate the weighted average cost of capital for this project, first of all the beta asset has been computed for comparable companies shown in Exhibit 3 a of the case. These companies have been used because they produced the same product and thus their risk would be similar for this business segment.
Using this beta asset, the beta equity for PC has been computed using a target capital structure of 30% debt and 70% equity. The cost of equity has been calculated using the Capital Asset Pricing Model. Risk free rate has been provided which is 6%, return on market has been calculated by averaging the market returns from exhibit 2 for period 1973 to 2000. The cost of equity using CAPM is 16.48% including floatation costs of new equity issue. The cost of debt has been assumed to be equal to the recent 10-year bond issue of the company at coupon rate of 8%. The financial calculator has been used to compute its yield to maturity which has been used as the cost of debt for PC. The cost of debt after tax is 4.73%. Using these inputs, the cost of capital for PC is 13.23%.
Net Present Value & IRR
Using the net cash flows and the cost of capital of 13.23%, the net present value for the front end loader project has been computed which is $ 133.32 million. The internal rate of return for this project has also been computed using the initial gross investment of $ 18.18 million. The IRR for this project is 86% which is quite a huge return.
Outboard Motor Project
This is the second investment option for PC Company. This project would allow the company to remain within the leisure craft market and also utilize its existing selling network.
Annual Cash Flows
The annual cash flows have been computed for the 20 year life of this project with gross investments in year 0 and salvage value realization in last year. There would be no cash flows associated with the sales team development as the sales team already exists however, sales commission would still be paid to the sales people. The calculations for the net cash flows for this project could be seen in the excel spread sheet.
Weighted Average Cost of Capital
The risk for this project would be equal to the current level of the risk of the company therefore, using the current beta of PC of 1.38 and all the other inputs for front end loader project the cost of capital for this project would be 12.89%.
Net Present Value & IRR
Using the above calculated annual cash flows and the cost of capital of 12.89%, the net present value for the Outboard Motor project is $ 11.99 million with an IRR of 21%. These values are quite low as compared to the values for Front end loader project however, still they are positive.
Evaluation of Financing Options
In order to undertake both the above projects or any one project, the management of the company would require extensive financing to fund these projects. Traditionally, the management of the company has been relying on its internally generated funds and the debt of the company to fund its projects.
Most of the times, the management had to delay certain profitable and lucrative projects because of the lack of internally generated funds. However, since the current projects which are being considered by PC company are larger in scope and size therefore, the management of PC expects to raise around $ 20 million in new equity for these project. The three main financing options for the company are as follows:
The first financing option for PC is to finance its projects through the internally generated funds. These are also known as retained earnings and these are the parts of the profits which are kept aside by the management of the company to meet their future needs. This is also called as the ploughing back of the profits. This is one of the most important sources of financing which is used for fixed investment and for meeting the working capital needs of the firms.
Pros: The main advantage of retaining earnings is that this financing method has zero cost of financing and the company is not obliged to pay any other party for using its internally generated funds. The use of the retained earnings for the own use of the company strengthens the financial position and economic stability of the company. The retained earnings enhance the market value of the company and this strengthens the financial position of the companies.
Cons: There are also risks for using the internally generated funds for financing the operations or specific projects of the company. The company faces the risk of over capitalization. The improper use of retained earnings might result in financial deficiencies for the company in future years. Finally, if the company has a policy to use retained earnings for its business purposes, then the shareholders are not able to enjoy the full benefits of the earnings of the company through increased dividends…………
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