Corporate Finance - Evaluating an Investment in Expansion - Case Study Example

CORPORATE FINANCE – CASE STUDY ANALYSIS CPA Dracker, Address Telephone Tucker Hansson, Address Telephone 19th April 2015 RE: EVALUATION OF THE PROPOSED EXPANSION PROJECT Having been appointed to advise on the prospects and benefits likely to accrue from the proposed expansion, this report focuses on the expected free cash flows, reasonability of the underlying assumptions as put by Robert Gates, determination of WACC and benefits of using debt capital to finance this project. Free cash flows analysis To establish the free cash flows from this project, this report took several steps. First this report computed the expected incremental incomes from the sale of the anticipated output products over the ten year period. In the year 2009, the incremental income is forecasted to be $84,960, $93,881 in 2010, $103,124 in 2011, $112,700 in 2012, $122,618 in 2013, $132,887 in 2014, $135,545 in 2015, $238,256 in 2016, $141,021 in 2017 and $143,841 in 2018. The next step was to establish the variable costs, which varied directly with the changes in the level of output from the new equipment. This report considered the material costs, labour costs, maintenance costs and manufacturing overheads as variable costs. In computing the material costs, this report used the forecasted relationship between the incremental revenue and the material costs, and this relationship started at 0.94 in 2009 and continued to increase by one percent every subsequent year. From this relationship, the computed material costs were $45,120 in 2009, $49,400 in 2010, $53,760 in 2011, $58,200 in 2012, $62,720 in 2013, $67,320 in 2014, $68,000 in 2015, $68,680 in 2016, $69,360 in 2017 and $70,040 in 2018. Added together, the variable costs were $69,610, $75,659.30, $82,808.40, $89,847.60, $97,478.80, $104,989.50, $106,955.60, $108,963.50, $111,016.60, and 113,118.20 in 2009, 2010, 2011, 2012, 2013, 2014, 20015, 2016, 2017, and 2018 respectively. After subtracting these costs from the revenues, contribution was established. In the year 2009, it was $15,350, $18,221.70 in 2010, $20,315.60 in 2011, $22,852.40 in 2012, $25,139.20 in 2013, $27,897.50 in 2014, $28,589.40 in 2015, $29,292.50 in 2016, $30,004.40 in 2017, and $30,722.80 in 2018. Later, the selling and administration expenses of $6,626.88, $7,322.72, $8,043.67, $8,790.60, $9,564.20, $10,365.19, $10,572.51, $10,783.97, $10,999.64 and $11,219.60. calculated based on the yearly sales and deducted from this contribution to get operating incomes before interest, depreciation and tax of $8,723.12, $10,898.98, $12,271.93, $14,061.80, $15,575.00, $17,532.31, $18,016.89, $18,508.53, $19,004.76, and $19,503.20 were arrived at. In computing the depreciation, this report considered the useful life of each equipment and prorated its cost over this life and a total depreciation of $4,000.00 each year was found and was subtracted from the operating incomes before interest, tax and depreciation, operating income before interest and tax was established. These incomes were $4,723.12, $6,898.98, $8,271.93, $, $10,061.80, $11,575.00, $13,532.31, $14,016.89, $14,508.53, $15,004.76 and $15,503.20 in 2009, 2010, 2011, 2012, 2013, 2014, 20015, 2016, 2017, and 2018 respectively. This report also computed the interest charge using the forecasted rate of the debt cost of 7.75%. The established results indicated that Hanson Private Label, Inc. will be required to pay an interests expense of $4,479.50 each year for the forecasted ten years. After charging this expense from the operating incomes before interest and tax, operating incomes before tax were established. These operating incomes before tax were $243.62, $2,419.48, $3,792.43, $5,582.30, $7,095.50, $9,052.81, $9,537.39, $10,029.03, $10,525.26 and $11,023.70 in 2009, 2010, 2011, 2012, 2013, 2014, 20015, 2016, 2017, and 2018 respectively. Since Hanson Private Label, Inc. operates under a tax jurisdiction where the tax rate is 40%, these operating incomes before tax were charged tax of 40%. This gave rise to operating incomes after tax of $146.17, $1,451.69, $2,275.46, $3,349.38, $4,257.30, $5,431.69, $5,722.43, $6,017.42, $6,315.16 and $6,614.22 in the years 2009, 2010, 2011, 2012, 2013, 2014, 20015, 2016, 2017, and 2018 respectively. Since depreciation is a non-cash item, this report added it back and established net cash flows of $4,146.17, $5,451.69, $6,275.46, $7,349.38, $8,257.30, $9,431.69, $9,722.43, and $10,017.42 in the year 2009, 2010, 2011, 2012, 2013, 2014, 20015, 2016, 2017, and 2018 respectively. Before establishing the free cash flows, this report first computed the net working capital that Hanson Private Label, Inc. would require in addition to the initial working capital each the forecasted years. By its very nature, the net working capital is computed by subtracting current liabilities from the current assets of an entity. From the Executive Vice President’s forecasts, this report used his elements of current assets which were the accounts receivable and the inventory while the itemised current liability itemised the accounts payable. However, these amounts were not expressly given, but their respective ratios were given such that the days sales outstanding would be 47.6x, days sales inventory would be 37.6x, and days payable outstanding would be 34.2x. Building from the knowledge that days sales outstanding is the debtors turnover and is computed by dividing annual credit sales by the number of debtors, this report was able to establish the accounts receivable amounts for each of the forecasted periods. It therefore divided the forecasted annual sales by the expected days sales outstanding to get accounts receivable of $11,233.60, $12,413.15, $13,635.28, $14,901.44, $16,212.82, $17,570.61, $, $17,922.06, $18,280.52, $18,646.11 and $19,018.98 in the year 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, and 2018 respectively. On the same note, since inventory turnover is computed by dividing cost of sales by the inventory amount, this report divided the cost of sales; in this case the cost of the raw materials was taken to be the cost of sales, by the inventory turnover. The results of these calculations indicated that the inventory amount in the year 2009, 2010, 2011, 2012, 2013, 2014, 20015, 2016, 2017, and 2018 would be $7,270.38, $7,902.19, $8,648.88, $9,384.08, $10,181.12, $10,965.57, $11,170.92, $11,380.63, $11,595.07, and $11,814.57 respectively. To calculate the amount of the expected accounts payable, this report assumed that Hanson Private Label, Inc. would be making the raw materials purchases on credit and it therefore divided the cost of these raw materials by the accounts payable turnover to get $6,612.95, $7,187.63, $7,866.80, $8,535.52, $9,260.49, $9,974.00, $10,160.78, $10,351.53, $10,546,58, and $10,746,23 in the year 2009, 2010, 2011, 2012, 2013, 2014, 20015, 2016, 2017, and 2018 respectively. To get the annual net working capital, this report added the computed amount of accounts receivable and the inventory and then subtracted the amount of accounts payable. This established a net working capital of $11,891.03, $13,127.71, $14,417.36, $15,750.01, $17,133.46, $18,562.18, $18,932.20, $19,309.62, $19,694.60, and $20,087.32 in the year 2009, 2010, 2011, 2012, 2013, 2014, 20015, 2016, 2017, and 2018 respectively. After the initial needed working capital in the year 2009, the annual increase in the net working capital was $310.71, $1,289.65, $1,332.64, $1,383.45, $1,428.72, $370.02, $377.42, $384.98 and $392.72 in 2010, 2011, 2012, 2013, 2014, 20015, 2016, 2017, and 2018 respectively. The free cash flows established after subtracting these increases in the net working capital were ($53,670.83), $5,140.97, $4,985.81, $6,016.74, $6,873.85, $8,002.96, $9,352.42, $9,640.00, $9,930.17, and $10,221.51 in the year 2008, 2009, 2010, 2011, 2012, 2013, 2014, 20015, 2016, 2017, and 2018 respectively. Reasonability of Executive Vice President’s Assumptions The assumption by Gates that the debt beta is zero could be right, but it could also not be true. Supporting Robert Gates assumption, he assumed that Hanson Private Label, Inc. will be honouring the interest on the borrowed debt capital for its expansion project. It will be paying it at a fixed amount and rate irrespective of the economic conditions. This means that Robert Gates assumed that there would be no volatility in the interest rate to imply further that there will be no risks and consequently its standard deviation id zero. However, this assumption must not always hold. First, there is a possibility that Hanson Private Label, Inc. would face difficulties paying the interest due, which is itself a risk. In addition, the lenders might adjust the cost of debt to reflect the general changes in interest rates. The assumption that the risk free rate will be 3.75% would hold since the government does not forfeit to pay its interest on the 10-Year Treasury bills. However, the market risk premium could not be reasonable since it was arrived by subtracting the risk free rate from the market returns. The market returns are subject to change given the inherent volatility of the economy. This report supports the tax rate that Robert Gates assumed would be appropriate because the relevant tax authority would not be in a hurry to change this rate. The estimated EBITDA multiple of 7x does not seem reasonable as it appears to be understated. From its previous performance, Hanson Private Label, Inc. has been recording EBITDA of more than 10% other than in the year 2005 when it was 7.7%. Determination of WACC WACC refers to the overall or composite cost of capital that a firm is currently using. To determine the WACC, the weighted average cost of each source of capital in the firm’s capital structure was used. In computing the Weighted Average Cost of Capital schedule, the average market value of debt to equity ratio of these firms was established since they financed their operations using debt and equity capital. To establish their overall effective cost of these sources of funds, an average after tax cost was established. This was achieved by establishing the WACC which is represented by the following function: rWACC = rE (E/V) + D/ V* rD (1-TC); where rE and rD are the percentage cost of equity and debt capital respectively and E and D are the market value of equity and debt capital respectively. The E/V represents the percentage of financing that is contributed by the shareholders while D/V is the percentage of financing that came from borrowings. V was arrived at after adding the equity financing (E) and debt financing (D) to get the total value of the firm. The TC stands for the corporate tax and was deducted for the tax shield enjoyed on the interest charge on the debt. However, the part of the percentage of equity financing (E/V) was expressed further manipulated to be represented by the debt equity ratio as is in the schedule. Since V= E+D, the V was substituted by E+D to get E/(E+D). Further manipulations were done and this was reciprocated to 1/(E+D)/E and when further substituted, it became 1/(1+D/E). Therefore, rewriting the WACC equation, it becomes WACC= 1/(1+D/E)* rE + D/ V rD (1-TC). The WACC in the schedule were then established using this equation as shown below. WACC 1 = This was calculated by taking the reciprocal of 1+ debt/equity (0.0%) which was then multiplied by the cost of equity (9.67%) and then the results were added to the debt cost (7.75%) less the tax shied effect (1-0.4) multiplied by the debt to firm’s value (0.0%). WACC 2 = The procedure above was followed but in this case, the debt/equity ratio was 5.3% and the fraction of debt financing was 5%. WACC 3 =  1/(1+11.1%)* 10.07%+10.0%*7.75%*(1-40%) = 0.0953 Similarly, this report used the same approach and worked with the debt/equity ratio of 11.1% and the debt/value ratio of 10.0%. WACC 4 = 1/(1+17.6%)* 10.30%+15.0%*7.75%*(1-40%) 0.0946 In calculating this WACC, the same procedure was followed but the debt/equity ratio used was 17.6% and the debt/value ratio was 15.0%. WACC = 1/ (1+25%)* 10.56%+20.0%*7.75 %*( 1-40%) = 0.0938 This report calculated this WACC by following the same approach but used a debt/equity ratio of 25% while the debt/value ratio changed to 20.0%. WACC = 1/ (1+33.3%)* 10.86%+25%*7.75 %*( 1-40%) = 0.0931 The final WACC was also computed through the same manner using a debt/equity ratio of 33.3% and a debt/value ratio of 25%. From all these WACC values, this report takes 9.31% as the most reasonable cost of capital to use in the case of Hanson Private Label, Inc. because it is the least yet it has considered the fact that equity capital is risky and therefore used the highest cost of equity. In addition, the firm will also be highly leveraged at this rate. Recommendation on the project This report recommends that Tucker Hansson drops the proposal to go ahead with the project. This decision was arrived at after evaluating the viability of this project using the project evaluation techniques. The future cash flows were all analysed including the release in the net working capital at the end of the project. Using the net present value1 of these individual items, this report established that Hanson Private Label, Inc. will have a net present value of ($4,856.67) as illustrated below. 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Revenue - 84,960.00 93,881.00 103,124.00 112,700.00 122,618.00 132,887.00 135,545.00 138,256.00 141,021.00 143,841.00 Less: Cost of Goods Sold - 69,610.00 75,659.30 82,808.40 89,847.60 97,478.80 104,989.50 106,955.60 108,963.50 111,016.60 113,118.20 Gross Profit - 15,350.00 18,221.70 20,315.60 22,852.40 25,139.20 27,897.50 28,589.40 29,292.50 30,004.40 30,722.80 Less: Selling, General & Administrative - 6,626.88 7,322.72 8,043.67 8,790.60 9,564.20 10,365.19 10,572.51 10,783.97 10,999.64 11,219.60 EBITDA - 8,723.12 10,898.98 12,271.93 14,061.80 15,575.00 17,532.31 18,016.89 18,508.53 19,004.76 19,503.20 Less: Depreciation - 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 EBIT - 4,723.12 6,898.98 8,271.93 10,061.80 11,575.00 13,532.31 14,016.89 14,508.53 15,004.76 15,503.20 Less: Interest Expense - 4,479.50 4,479.50 4,479.50 4,479.50 4,479.50 4,479.50 4,479.50 4,479.50 4,479.50 4,479.50 EBT (Earning before tax) - 243.62 2,419.48 3,792.43 5,582.30 7,095.50 9,052.81 9,537.39 10,029.03 10,525.26 11,023.70 Less: Tax (40%) - 97.45 967.79 1,516.97 2,232.92 2,838.20 3,621.13 3,814.96 4,011.61 4,210.10 4,409.48 Net income after tax - 146.17 1,451.69 2,275.46 3,349.38 4,257.30 5,431.69 5,722.43 6,017.42 6,315.16 6,614.22 Add back depreciation - 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 Net cash flows - 4,146.17 5,451.69 6,275.46 7,349.38 8,257.30 9,431.69 9,722.43 10,017.42 10,315.16 10,614.22 CAPEX (45,000.00) - - - - - - - - - Additional NWC (12,817.00) - - - - - - - - - Less increase in NWC - - (310.71) (1,289.65) (1,332.64) (1,383.45) (1,428.72) (370.02) (377.42) (384.98) 19,694.60 Free cash flows (45,000.00) (8,670.83) 5,140.97 4,985.81 6,016.74 6,873.85 8,002.96 9,352.42 9,640.00 9,930.17 30,308.82 Discounting factor {1/(1+r)^n) 1.0000 0.9148 0.8369 0.7656 0.7004 0.6408 0.5862 0.5363 0.4906 0.4488 0.4106 Discounted cash flows (Cashflows*DF) (45,000.00) (7,932.33) 4,302.55 3,817.30 4,214.26 4,404.54 4,691.28 5,015.39 4,729.31 4,456.74 12,444.29 Total discounted cashflows = (7,932.33)+4302.55+3817.30+4214.26+4404.54+4691.28+5015.39+4729.31+4456.74+12,444.29) Sum PV = 40,143.33 NPV = Sum PVs - Initial capital investment NPV = $40,143.33 - $45,000 NPV = (4,856.67) This value was arrived after discounting all the expected future cash flows that the expansion project is expected to generate using the required rate of 9.31%. By zeroing in on this decision, this report found that there were no other selection criteria that Tucker Hansson had set to guide in rejecting or accepting this project. Therefore, it was rejected because it has negative net present values. In using the net present value approach, this report used some assumptions for the NPV technique to hold. First, this report assumed that the cash that this project will generate, Hanson Private Label, Inc. will immediately reinvest it in order to generate some returns at a rate of the discount rate. The second assumption is that the cash flows will be occurring at the end of each period other than the initial investment cost. The third assumption is that the changes in fixed costs represent the loss in dollar’s purchasing power as an inflation factor. Benefits that Hanson Private Label, Inc. is likely to enjoy for using debt capital to finance this expansion project In the normal day to day operations of a business, companies use debt financing when constructing their capital structure since it helps in lowering the total investment costs. The use of debt amounting to $57.8 million by Hanson Private Label, Inc. was a sensible choice of funds for the immense benefits that will accrue from it. In the first place, Hanson Private Label, Inc. will enjoy some reductions in costs. Compared to equity financing, the debt requires lower investment cost. By making the decision, to add the debt into its capital structure will have its average investment cost come down. In addition, the debt will have low issue cost as there is almost no issue costs involved as it would be if other sources of financing were used. Hanson Private Label, Inc. will also benefit from the use if the debt because of the tax benefits. From the interest expense that Hanson Private Label, Inc. will be paying to the lender, it is a tax deductible expense. Hanson Private Label, Inc. will be claiming this interest expense against its profits. This is different when other sources of financing such as equity and preference capital because the dividends they receive are paid after taxes from the net earnings. Therefore, Hanson Private Label, Inc. will benefit greatly from the tax shield of up to 40% of the interest expense. In other words, the effect of the tax shield will make Hanson Private Label, Inc. to pay an overall interest rate of 4.65% instead of the 7.75% cost of debt. This amount is established by subtracting the tax shield from the cost of the debt {7.75%* (1-40%)}. These tax savings will further add to lowering Hanson Private Label, Inc.s debt financing cost, which other funding sources lack. This tax shield will add to an increase in the cash flows since they will help in keeping more money in the company. In this case, Hanson Private Label, Inc. will enjoy a tax shield of $1,791,800 each year totalling to a tax saving of $17, 918,000. Hanson Private Label, Inc. will also benefit from the created financial leverage. Its owners will find debt financing advantageous from this financial leverage. This debt will be added to the expansion project and operations of Hanson Private Label, Inc. to assist it in making extra profits. The owners will enjoy the extra profits generated by this debt making them have higher returns because of the additional benefits. However, this benefit will always be enjoyed on the assumption that the use of this debt will not threaten its financial soundness in times of difficulties. Given that Hanson Private Label, Inc. will know that it has some obligations to meet in repaying the debt, as well as the accrued interest, there will be prudence in financial management particularly in regard to profit retention. During its ongoing operations, Hanson Private Label, Inc. will face pressure to realize enough profit and from which it will pay the accruing interest expense. In other words, it will instil discipline by making those involved in its management to be more cautious and committed to managing it and maintaining the cash flows effectively. This will ensure that Hanson Private Label, Inc. does not face the bankruptcy risks by the failure to pay interest on time. This differs from other financing sources such as the equity financing because it would not maintain such enormous profits because, the more profits it will make the more distributions it will make in the form of dividends. Therefore, if properly managed and run, Hanson Private Label, Inc. will be able to realize enough profits to pay the interest expense and retain the rest to its owners. The use of debt by Hanson Private Label, Inc. to finance this expansion will ensure that there is no dilution of its control. The existing owners will have their control over its operations unaffected as opposed to when the financing is done through equity financing. In the case of equity financing, the control over the operations of Hanson Private Label, Inc. would dilute proportionately. In addition, the use of debt will ensure that there is no dilution in profit sharing. The profit sharing percentage of the current owners will remain intact since the entity issuing this debt will in no way be a party to the profits made other than their interest revenue. This implies that, the same number of hands that existed in Hanson Private Label, Inc. and shared profits before the project was proposed and after its proposal and implementation are the same numbers of hands. This condition would definitely be different if equity financing was used since other hands will have been invited. References Stafford, E., Heilprin, J.L. & Devolder, J., 2010. Hansson Private Label, Inc.: Evaluating an Investment in Expansion. Case Study. Watertown, Massachusetts: Harvard Business Publishing Harvard Business School. Read More