Assignment Overview
Rio Claro, Inc. (RCI) is in the business of transporting cargo between ports in California and Washington. Its fleet includes a small dry-cargo vessel, the Maracas. The Maracas is 25 years old and badly in need of an overhaul.
It is March 2016, and Michael John, the finance director, has just been presented with a proposal that would require the one-time expenditures shown below in Table 1. If the proposal is accepted, these expenditures will be made in the next few days. Mr. John believes that all these outlays could be depreciated for tax purposes in the seven-year MACRS class (see Table 2 below for rates). Overhaul of the Maracas will begin as soon as the expenditures in Table1 are made, but the vessel will be out of service for several months. The overhauled vessel would resume commercial service in one year. RCI's chief engineer's estimates of the post-overhaul operating costs are in Table 3.
In addition to the overhaul described above, the chief engineer suggests installation of a brand- new engine and control system. Installation of this new engine would cost an extra $600,000 (This additional outlay would also qualify for tax depreciation in the seven-year MACRS class.). However, if the additional equipment is installed, it would result in reduced fuel, labor, and maintenance costs as shown in Table 4.
The operating cost estimates in Tables 3 and 4 are current for March 2016. However, these costs will increase with inflation, which is forecasted at 1.25% a year. Depreciation and operating costs attributable to the overhaul of the Maracas will begin one year after the vessel is put back into commercial service. The revenues from operating the vessel will be the same for both types of overhaul.
Even with the proposed overhaul, the Maracas cannot continue forever. After the overhaul, its remaining useful life is estimated to be only 12 years. Its salvage value when finally taken out of service will be trivial. Thus, Mr. John feels it is unwise to proceed without also considering the purchase of a new vessel. Racette & Sons (R&S), a Colorado shipyard, has approached RCI with a design incorporating a Kort nozzle, extensively automated navigation and power control systems, and much more comfortable accommodations for the crew. R&S is offering the new vessel for a fixed price of $3,000,000, payable half immediately and half on delivery in one year. Estimated annual operating costs of the new vessel are in Table 5. The operating cost estimates in the table are current for March 2016, but will increase with inflation.
The crew would require additional training to handle the new vessel's more complex and sophisticated equipment. Training would result in a one-time cost of $50,000 payable one year following delivery of the new vessel. This cost is tax deductible.
The estimated operating costs for the new vessel assume that it would be operated in the same way as the Maracas. However, the new vessel will be able to handle a larger load on some routes, which is expected to generate additional revenues, net of additional operating costs, of approximately $175,000 per year in the first year of operation. These revenues are expected to grow at the rate of inflation. Revenues and operating costs from the new vessel will begin one year after it is delivered. The new vessel is estimated to have a useful service life of 20 years, but it will be depreciated for tax purposes according to the 7-year MACRS schedule. The new vessel is not expected to have any resale value at the end of its 20-year useful life. All revenues and costs (including depreciation) associated with the new vessel will begin one year after it is delivered.
The Maracas is carried on RCI's books at a book value of only $100,000, but could probably be sold "as is," together with its extensive inventory of spare parts, for $200,000. The book value of the spare parts inventory is $40,000.
Mr. John stepped out on the foredeck of the Maracas as she chugged down the Cook Inlet. "A rusty old tub," he muttered, "but she's never let us down. I'll bet we could keep her going until next year while Racette & Sons are building her replacement. We could use up the spare parts to keep her going. We should even be able to sell or scrap her for book value when her replacement arrives."
RCI evaluates capital investments of this type using a 8.5% cost of capital. (This is a nominal, not real, rate.) RCI's tax rate is 35%.
Table 1: Overhaul Expenditures
Overhaul engine and generators $340,000
Replace radar and other electronic equipment
75,000
Repairs to hull and superstructure
310,000
Painting and other repairs
95,000
$820,000
Table 2: Depreciation (in %) for the 7-year Modified Accelerated Cost Recovery System
Year 1
14.29
Year 2
24.49
Year 3
17.49
Year 4
12.49
Year 5
8.93
Year 6
8.93
Year 7
8.93
Year 8
4.45
Table 3: Post-overhaul Operating Costs (Basic Overhaul)
Fuel
$450,000
Labor and benefits
480,000
Maintenance
141,000
Other
110,000
$1,181,000
Table 4: Post-overhaul Operating Costs (Overhaul plus new engine & contro system)
Fuel
$400,000
Labor and benefits
405,000
Maintenance
105,000
Other
110,000
$1,020,000
Table 5: Operating Costs of New Vessel
Fuel
$380,000
Labor and benefits
330,000
Maintenance
70,000
Other
105,000
$885,000
Guidelines for Case Analysis
The following aids are permitted for this analysis: You may use internet sources, books, all posted materials (including Discussion Board Q&A), and your notes.
Any other aids are unauthorized and their use constitutes a violation of academic integrity. This includes face-to-face or electronic correspondence concerning the specific details of the case with any other person that is not a member of your assigned group, whether or not they have current or past affiliation with Washington State University.
The case is due on the date indicated on the course schedule. Late papers may be accepted with a reasonable excuse, but will be assessed a 20% grade reduction penalty. Cases should be typed in 12- point font, double-spaced, with a minimum of 1 inch margins.
The case report should be written according to the following format:
Introduction
Analysis
Conclusion
The introduction sets the stage for the work to follow and should consist of a short paragraph of the key problem(s) or issue(s) that your analysis addresses. The analysis will constitute the bulk of the written presentation and will be a direct response to the questions below. Use clear, concise, and complete sentences. Do not use bullet points or numbered paragraphs. The conclusion should be a short paragraph that summarizes the key points of the analysis.
Your report should not exceed five pages of double-spaced text with 1 inch margins at the sides, top, and bottom of the page. This does not include exhibits of your computations. You may submit one Excel Spreadsheet that contains all your exhibits, clearly labeled, and appropriately referenced in the text of your report.
Your analysis of "Rio Claro, Inc." should consist of answers to the questions below. Do not write the questions verbatim in your report. Instead, write a brief introductory statement that summarizes the question before you proceed with your analysis.
Calculate the present value of the proposed overhaul of the Maracas, with and without the new engine and control system. Should RCI do the basic overhaul or the expanded overhaul with the new engine and control system? For the moment, ignore the option to purchase a new vessel (you will evaluate that option in question 2 below).
Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 1.
Calculate the present value of buying and operating the new vessel. What, if any, additional information would be useful to you in your analysis?
Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 2.
Calculate the equivalent annual costs of (a) overhauling and operating the Maracas for 12 more years (with and without the new engine and control system) and (b) buying and operating the proposed replacement vessel for 20 years. You should use the real discount rate for this analysis. Based on your answer, what should RCI do?
Write one to two paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 3.
Why is the equivalent annual cost method potentially useful in decision making in this case? Why would you use the real discount rate to compute the EAC? What problem(s) do you see with using the equivalent annual cost method to evaluate RCI's options?
One to two paragraphs.
Your report is intended for the senior management of Rio Claro, Inc., so be sure that you write in a professional style that is easy to follow.
Mini Case #2: Waltham, Inc.: Acquisition of Artforever.com
Assignment Overview
Waltham, Inc., a publicly traded firm, is considering the acquisition of a private company, Artforever.com, which specializes in restoring damaged artwork and vintage photographs for high net worth individuals. Waltham's CEO and chairman of the board, Willie Ray, described the motivation for the acquisition as follows: "We are running out of profitable investment opportunities in our core vintage shoe restoration business, and our shareholders expect us to continue to grow. Therefore, we must look to acquisitions to expand into growing markets."
Waltham, Inc.'s common stock is currently trading at $50 per share, and the firm has 100,000 shares outstanding. The book value of the common stock is $20 per share. However, as mentioned by Mr. Ray, sales had been slowing recently and the board was concerned that soon the share price would also begin to flag as investors figured out that the firm was running out of positive NPV investments. The firm has $2,000,000 market value of bonds trading at a yield to maturity of 6.2%.
You have been hired as a consultant to Waltham to evaluate the proposed acquisition of Artforever.com. There is considerable dissension among senior management and the board about whether the acquisition should be undertaken. Your job is to perform a thorough analysis of the merits of the proposed acquisition and make a recommendation to senior management.
After several meetings with Waltham management and a review of Artforever's financial performance and industry structure, you gathered the data shown in Table 1 below.
Forecast Data for Artforever.com (in
000)
2017
2018
2019
2020
2021
Sales Revenue
1,000.0
1,250.0
1,875.0
2,100.0
3,750.0
Investment in CapEx and NWC
25.0
55.0
170.0
80.0
80.0
Depreciation
15.0
30.0
50.0
72.0
80.0
Interest payments
94.4
101.4
108.6
115.9
122.4
Artforever.com currently has $1,475,000 (market value) in long-term debt, with a coupon rate of 7%. Its cost of goods sold (COGS) is expected to be 42% of sales revenues, and selling, general and administrative (SG&A) expenses are expected to be 15 percent of revenues. The depreciation numbers listed above are already included in COGS percentage estimates. The firm's corporate tax rate is 40% and its current cost of borrowing is 6.2%.
Your research indicates that Artforever has a target debt to value ratio of 15%, based on its assessment of the probability and costs of financial distress. You note that this is different from the capital structure of Waltham and wonder how this would factor into your analysis.
Although Artforever.com is a rapidly growing company, your analysis of industry structure suggests that competition in the art restoration market is likely to increase in the next few years. Thus, you forecast that the perpetual growth rate for free cash flows beyond 2021 will be a more modest 2.0% per year.
Your analysis of market data yielded the information in Table 2 below.
Market Data
Current yield to maturity on 30 year treasury bonds
2.50%
Current yield to maturity on 3 month treasury bills
2.0%
Most recent 1-year return on the S&P 500
5.3%
Estimate of expected average return on the S&P 500 over the next 30 years
8.0%
Your analysis of Artforever.com's industry reveals that most of the firms in the industry, like Artforever, are private firms. However, you find a close competitor, ArtToday.net, that is in the same line of business and is publicly traded. ArtToday has a long-term target debt to equity ratio of 0.75, and has been historically quite close to that target. Your analysis of ArtToday's historical returns against the market returns yields an equity beta of 1.5. ArtToday currently has 50,000 common shares outstanding trading at $12 per share.
Guidelines for Case Analysis
The following aids are permitted for this analysis: You may use internet sources, books, all posted materials (including Discussion Board Q&A), and your notes. Any other aids are unauthorized and their use constitutes a violation of academic integrity. This includes face-to-face or electronic correspondence concerning the specific details of the case with any other person that is not a member of your assigned group, whether or not they have current or past affiliation with Washington State University.
The case is due on the date indicated on the course schedule. Late papers may be accepted with a reasonable excuse, but will be assessed a 20% grade reduction penalty. Cases should be typed in 12-point font, double-spaced, with a minimum of 1 inch margins.
The case report should be written according to the following format:
Introduction
Analysis
Conclusion
The introduction sets the stage for the work to follow and should consist of a short paragraph of the key problem(s) or issue(s) that your analysis addresses. The analysis will constitute the bulk of the written presentation and will be a direct response to the questions below. Use clear, concise, and complete sentences. Do not use bullet points or numbered paragraphs. The conclusion should be a short paragraph that summarizes the key points of the analysis.
Your report should not exceed five pages of double-spaced text with 1 inch margins at the sides, top, and bottom of the page. This does not include exhibits of your computations. You may submit one Excel spreadsheet that contains all your exhibits, clearly labeled, and appropriately referenced in the text of your report.
Your analysis of "Waltham, Inc." should include answers to the questions below. Do not write the questions verbatim in your report. Instead, write a brief introductory statement that summarizes the question before you proceed with your analysis.
What discount rate is appropriate for finding the value of Artforever.com?
Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 1.
What are the relevant cash flows for valuing Artforever.com? Assume that your valuation is performed at the end of 2016, and that the values shown in Table 1 are end-of-year forecasts.
Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 2.
Based on your answers to questions (1) and (2) above, what is the maximum price that Waltham should pay to equity shareholders for Artforever.com?
Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 3.
Under what conditions might you consider recommending that management make a higher offer than your recommended price in (3) above?
No computations are necessary, just a short discussion.