Case study 7
International Research Journal of Applied Finance ISSN 2229
– 6891
Vol. VI Issue – 1 January, 2015 Case Study Series
Project Evaluation: Tortuga Fishing Equipment Company
Judson W. Russell
As modified by Professor Keller
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.
Introduction
Brooks Hamilton recently accepted a job with Tortuga Fishing
Equipment Company1 (Tortuga) in the company’s 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 company’s 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 firm’s 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.
Tortuga’s 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 (Megalopsatlanticus). 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 “gold standard” 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 (not to exceed 1 year) 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 points. The
remaining $175 million credit line can be assumed to have no fees associated
with it. 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% for the average market return.
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 & Poor’s (S&P) 500 returns. There are a
variety of methods for calculating beta.
Brooks onlyhas 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
Year Tortuga
Return S&P 500 Return
1 12 7
2 22 16
3 -2 -3
4 14 9
5 9 8
6 19 21
7 16 17
8 -10 -5
9 7 9
10 12 14
Source: Author
After Brooks calculates beta he employs CAPM along with the
risk-free rate and average market return rate to determine the cost of equity.
The firm’s 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.
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 Figure1 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 itsinventory 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 firm’s
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 1 Project Net Cash Flows for Tortuga Fishing
Equipment ($thousands)
Year Project A Project B
1 -900 950
2 200 950
3 900 950
4 1800 950
5 2500 950
6 2500 950
7 1800 950
8 1200 950
9 800 950
10 200 950
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.
Specific Questions
1. Using the Capital Asset Pricing Model, what is the
required rate of return on equity, Re(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 firm’s
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?
Author
Judson W. Russell, Ph.D, CFA
Clinical Professor of Finance, Belk College of Business,
University of North Carolina Charlotte,
jrussell@uncc.edu
As modified by Professor William Keller
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