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International
Research Journal of Applied Finance ISSN 2229 â 6891
Vol. VI
Issue â 1 January, 2015 Case Study Series
Project
Evaluation: Tortuga Fishing Equipment Company
Judson W.
Russell
Abstract
This case
study on project evaluation is applicable for beginning courses in corporate
finance or finance strategy. Two alternative 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 to be evaluated carefully and decision should be made on the basis of
thorough analysis of the data available using various capital structure and
capital budgeting techniques.
Keywords:
Beta, Corporate Finance, Cost of Capital, Internal Rate of Return, Net Present
Value
JEL Code:
C10, G31, G32
Introduction
Brooks
Hamilton recently accepted a job with Tortuga Fishing Equipment Company1
(Tortuga) in the companyâs finance department. His first few assignments were
fairly straightforward and Brooks relied on his background in both accounting
and finance to get his career off to a great start. His manager, the companyâs
Chief Financial Officer (CFO) was impressed with his work and decided to put
Brooks on a new assignment. The firm was embarking on a new project which would
define its future over the upcoming years. Given the importance of the project
and
high degree
of visibility with the firmâs senior management, Brooks was flattered to be asked
to assist and eager to show that he was up to the task. The finance department
was tasked with preparing an analysis to make a decision between two competing
project plans which could very
well decide
the future of Tortuga in the competitive fishing equipment industry. The Chief
Executive Officer (CEO) wants to have an answer from finance and expects a
thorough analysis very quickly.
The
Company
Tortuga
is an Islamorada, Florida based company specializing in manufacturing
high-end fishing rods and reels. Tortuga was founded by a retired university
professor who fished all of his life and wanted to create the best equipment
possible to handle a variety of fishing conditions and fish species. He
partnered with an engineer who ran a machine shop to produce some prototype
reels and supplied these to commercial fishing captains as test market
research. The equipment
produced by
Tortuga was a significant improvement over the current line available and
orders were strong. Through the years, the company made some modest
improvements to their original prototype and had become an industry leader.
Tortugaâs
products are used by tournament fishing teams around the world. Over the past
decade, tournament fishing has grown to become a big business with corporate
endorsements and prize
money.
This growth has made what was once a recreational vocation into a full-time
profession for some anglers.
The
company recently launched an extensive research and development effort focused
on a new flyrod and reel designed for one particular species of fish,
the Atlantic Tarpon (Megalops atlanticus). Tarpon are long-lived fishes
that migrate in the warmer climes of the Caribbean Sea,
Gulf of
Mexico, and along the Atlantic Ocean coastlines. Although the fish can
reach lengths of eight feet (~2.4 meters) and weights of 280 pounds (127
kilograms), they inhabit the shallow flats and exhibit acrobatic leaps when
hooked. These traits make tarpon a popular game fish for anglers. Fishing gear
needs to be sturdy to handle the power of these fish and Tortuga had developed
products for this niche market which were allowing anglers to be successful in
their angling pursuits.
Recently,
several sponsors had come together to launch competitive angling events called
tournaments, where the best anglers vie to catch, and then release, the most
and largest tarpon. Winners may receive up to $50,000 in a single weekend
tournament and the difference between
winning and
losing could be a few pounds. With so much money at stake, tournament teams
purchase the best gear available and are always looking for any competitive
advantage with their equipment. Tortuga is looking to capitalize on this trend
by offering a new line called the Tortuga Tarpon Classic. This new line
incorporates the latest material and design improvements and is predicted to be
the âgold standardâ for all serious tournaments anglers. Tortuga plans to offer
the Tortuga Tarpon Classic to recreational anglers as well to capture the
growing demand by affluent anglers who want the same high-quality gear as the
professionals.
Financial
Information
Tortuga
began with a modest amount of capital that the founder had managed to save
during his years in academia. As the firm grew, its financing needs expanded as
well. Through the years Tortuga had developed and maintained a strong
relationship with a large bank which provided
short-term working
capital funds in the form of a revolving line of credit. When a funding need
arose, Tortuga would draw from this line of credit and then repay the
short-term draw as cash flowed back to Tortuga. The $200 million revolving line
of credit currently has $25 million
drawn at
an interest rate of 3-month Libor plus 350 basis points2. The remaining $175
million credit line can be assumed to have no fees associated with it3. Brooks
looks up the most recent 3- month U.S. dollar Libor rate and sees that it is
1.50%.
Long-term
financing was also in place in two forms. After several years of revenue and
earnings growth, Tortuga issued five million shares of common stock at an issue
price of $10 per share. The firm used this $50 million in funding to increase
production lines and build a global
presence by
opening an additional manufacturing facility in Panama. Brooks finds the
current 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 interest
semi-annually and
is currently trading in the market at 102.50 as a percent of par. The company
has a 34% corporate tax rate.
The firm
calculates its required return on equity with the Capital Asset Pricing Model
(CAPM) using a 4.0% historical Treasury rate for the risk-free rate and 6.0% as
the historical market risk premium4.
CAPM =
Risk-free rate + beta (Market Risk Premium)
The
annual stock returns versus the market are shown in Figure 1 below for the past
10 years. Beta is calculated by regressing Tortuga stock returns on the
Standard & Poorâs (S&P) 500 returns. There are a variety of methods for
calculating beta. Brooks could find beta by regressing
five years
of weekly Tortuga returns of the S&P 500. He could use five years of
monthly returns or two years of weekly returns. Each of these is a valid sample
period. One well-known data source provides an âadjustedâ beta which is
determined by first calculating a ârawâ beta by regressing two years of weekly
security returns on the market. This is then adjusted by taking 2/3 of the raw
beta plus 1/3 of one. This adjusts the beta to be closer to one, since beta is
not stationary and should naturally move towards one through time as a firm
expands. Brooks only has 10 years of annual data available at the time and
decides to conduct the analysis with this information to get a quick response.
He will check his result with more data points before submitting his final
report to the CFO.
Figure
1 Returns on Tortuga Stock versus the Standard & Poor 500
Year
Tortuga Return S&P 500 Return
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Year
Tortuga Return
S&P 500 Return
1
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Source:
Author
After
Brooks calculates beta he employs formula (1) above along with the risk-free
rate and market risk premium to determine the cost of equity. The firmâs
weighted average cost of capital is a function of its equity market
capitalization, cost of equity, short- and long-term debt amounts
and costs,
and the tax rate. Using formula (2) below, Brooks can find the firmâs 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=
Companyâs before tax rate
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 owners will need to calculate beta
Rm= equity
risk premium
Tortuga
Tarpon Classic
The
company has two separate research teams working on the project and they develop
two distinctly different fishing combinations. The two rod and reel
combinations are test marketed with guides and past tournament champions and
demand forecasts are determined. Most fishing gear has a relatively short life
due to continual product innovation. Manufacturing of the two combinations is
estimated to require an upfront cost of $5 million to retool the machine shop.
The process for manufacturing the two combinations differ and ongoing variable
costs are not the same. The net cash flows for the entire ten year expected
life of the product is shown in Table 2 as Project A and Project B (all figures
are $thousands of net cash flow).
Project A
focuses on hand tooled fishing equipment which results in a more labor
intensive process, but also allows for personalized features for customers. The
price charged for customization offset the slower hand tooling process to
generate substantial net cash flows. Part of the upfront $5 million includes
the costs of training more machinists in the art of hand tooling, which is
similar to watch making but with a few less moving parts. Project A is
anticipated to generate lower cash flows in the early years due to the length
of time required to get machinists
who are
adept at hand tooling to customer specifications. In fact, during the first
year there will be continued expenses to attain these skills which causes
year one net cash flows to be negative. Over time the cash flows
increase as more machinists gain proficiency. The project is expected to
experience lower cash flows towards the end of its life due to market
saturation. Due to the quality of the reels, they are built to last and seldom
fail or wear out. Technological obsolescence is certain although Tortuga will
be investing cash flows into research and
development to
launch the next generation at the conclusion of the Tortuga Tarpon Classic life
cycle.
Project B
employs a mechanized approach to large scale production of standardized
equipment. Although the approach does not allow for personalization, it does
allow Tortuga to build its inventory quickly and capture positive net cash
flows immediately. The upfront expense is
almost completely
devoted to tooling equipment procurement and the number of units produced will
be much higher and at lower price points than the approach of Project A. At the
end of both projects life it is assumed that there will be zero salvage value
as the pace of innovation will
require a
complete re-tooling for the next generation and the useful life of the
equipment will have been fully realized.
Brooks
realizes that he will need to calculate the firmâs cost of capital discount
rate and apply this to the cash flow projections of both projects. He recalls
all of the assignments he completed at university and is thankful to have been
so well-prepared for this task. He gets a cup of coffee, sits down at his desk,
and gets to work.
Figure 2
Project Net Cash Flows for Tortuga Fishing Equipment ($thousands)
Year
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Project A
Project B
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Source:
Author
Since
Brooks is new to his role, you have been asked to review his work and assess
the financial viability of the projects. Given the importance of this decision
you are helping to make sure the firm makes the right choice.
Notes:
1. Fictitious
company created to illustrate corporate finance principles.
2. Libor
is an acronym for London Interbank Offered Bank, which is a standard floating
interest rate benchmark for
credit facilities.
A basis point is equal to 1/100th of 1%. One percent is 100 basis points.
3. Typically
a bank will charge a facility fee for the entire credit facility, $200 million
in this case and an interest rate
based on
utilization. We assume no facility fee for simplicity.
4. The
risk-free rate is determined based on the geometric average of the long-term
Treasury. The market risk
premium is
calculated based on the difference between the geometric return on the Standard
& Poorâs 500 index and
the long-term
Treasury.
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 the
capital structure? (Rd
& Re)
3. Using
the information provided, what is the firmâs weighted average cost of capital
(WACC)?
4. What
are the net present value (NPV), internal rate of return (IRR), and Payback
Periods for Projects A & B?
5. What
decision rules will you use to help Tortuga reach a decision?
6. What
are the strengths and weaknesses of each of the evaluation tools?
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