Precision Putters Inc. Precision Putters Inc. is a manufacturer of high quality
ID: 2720544 • Letter: P
Question
Precision Putters Inc.
Precision Putters Inc. is a manufacturer of high quality putters for the golfing industry. The company was started eight years ago by Jake Johnson. Jake was an avid golfer with a background in the metalworking industry. As a hobby, he started making putters for himself and some of his friends. As he and some other users of his putters had some success in local amateur tournaments, the reputation and demand for his putters increased. He soon found that he was getting enough requests for his putters that he quit his job at a machine shop and formed Precision Putters Inc. He started his operation with a couple of pieces of machinery in his garage. However, within two years, business was good enough that he moved his operations to a 30,000 square foot manufacturing facility.
The company now sells its putters worldwide and several professional players have won tournaments using Precision Putters (which has obviously helped to boost demand).
The management of Precision Putters is currently evaluating the purchase of a new high-speed computerized grinding machine to replace its existing grinding machine.
Sally Smith, a recent Geneseo Business School graduate who is now working at Precision Putters as a financial analyst, must analyze this project and present her findings to the company’s executive committee.
The new machine costs $710,000 and shipping and installation cost would total $10,000. In addition, installation of the new equipment would cause Precision Putters’ inventories to increase by $6,500, accounts receivable to increase by $4,000, and accounts payable to increase by $3,500. The company plans on using the new machine for 5 years. The new machine would be depreciated under MACRS using a 5-year recovery period. It is expected that the new machine can be sold for $95,000 at the end of 5 years.
The existing machine can be sold currently for $112,000 before taxes. It is 4 years old, cost $420,000 new, and is being depreciated as a 7-year class asset under MACRS. It is expected that the existing machine can be sold for $10,000 at the end of 5 years.
The new machine is expected to generate $385,000 in profits before depreciation and taxes for each of the next 5 years. The existing machine is expected to generate $190,000 in profits before depreciation and taxes for each of the next 5 years. The firm is subject to a 40% tax rate on both ordinary income and capital gains.
The section of the building where the new piece of equipment would be installed has been unused for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, the company spent $30,000 to rehabilitate that section of the building. Jake Johnson is not sure but thinks that maybe this outlay, which has already been paid and expensed for tax purposes, should be charged to this new equipment project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $30,000 to make the site suitable for the new equipment.
Precision Putters has a target capital structure of 40% debt, 10% preferred stock, and 50% common equity. The investment banker believes that 10 year, 9% coupon, $1,000 par value bonds could currently be sold, with a flotation cost of 3% of par value. The firm could sell, at par, $100 preferred stock which pays a 12% annual dividend, and flotation costs of $5.00 per share would be incurred. The company’s common stock has experienced a constant dividend growth rate of 8%, and the company recently paid a dividend of $2.10. The stock is currently selling for $30.00 per share. Any new common stock issued would incur an 8% flotation cost. Management assumes that all new projects will require the issuance of new common stock, and the firm’s weighted average cost of capital to should be used to evaluate the project.
Sally was asked to analyze the project, and then present her findings to the company’s executive committee. Since some members of the executive committee have a very limited knowledge of capital budgeting techniques, Sally wants to help to educate them. Therefore, she has decided to ask and then answer a series of questions as set forth below.
Questions
1.Should the money that was spent to rehabilitate the plant last year be included in the analysis? Explain.
2.What is Precision Putters’ net initial investment for this project (Year 0 net cash flow)?
3.Define incremental cash flow, and then set forth the project’s operating cash flow statement for each year of operations. What is the expected non-operating terminal cash flow when the project is terminated at Year 5?
4.What is the firm’s cost of capital? (Show the calculation of each of the three component costs)
5.What is the project’s NPV? (Remember to analyze the project’s relevant incremental cash flows including the terminal cash flow in year 5) Explain the economic rationale behind the NPV.
6.What is the project’s IRR? Explain the rational for using the IRR to evaluate projects. Which of the two methods (NPV and IRR) is theoretically superior and why?
7.What is the project’s payback period? What is the rationale behind the use of payback period as an evaluation tool? What are some drawbacks with this method?
8.What overall recommendation would you make regarding this project?
Explanation / Answer
1.Should the money that was spent to rehabilitate the plant last year be included in the analysis? Explain.
It should be simple enough to understand that only incremental cash flows are considered in a capital budgeting decision. However, a common pitfall is counting costs already paid or incurred the liability to pay for in the past. This is what is called a sunk cost.
In the case, the $30,000 spent to rehabilitate facilities should not be included in the analysis.
The firm has already paid for this rehabilitation, whether they decide to take on the project or not. The $30,000 should not affect the decision to be made as it has already been incurred in the past. The expense cannot be undone.
Based on the definition of incremental cash flows, which is the basis for performing capital budgeting analysis, this is not a relevant cost to the decision at hand. Whether or not the project will be undertaken, the expense will still be there. It does not change the firm’s future cash flow.
2.What is Precision Putters’ net initial investment for this project (Year 0 net cash flow)?
Initial Investment Outlay = machine cost + shipping and installation expenses + change in net working capital - After-tax proceeds from sale of the old asset
Computation of After-tax proceeds from sale of the old asset, depreciation based on 7years MACS.
Here, book value at the end of 4th year = 131,208
if sold in this year then sale value = 112,000
there is a loss of = 131,208 - 112,000= -19,208
change in net working capital = 6,500 +,4,000 - 3,500 = 7,000
Therefore,
Initial Investment Outlay = machine cost + shipping and installation expenses + change in net working capital - After-tax proceeds from sale of the old asset
= 710,000 + 10,000 + 7,000 - (-19,208)
=710,000 + 10,000 + 7,000 + 19,208 = 746,208
3.Define incremental cash flow, and then set forth the project’s operating cash flow statement for each year of operations. What is the expected non-operating terminal cash flow when the project is terminated at Year 5?
Computation of operating cash flows:
Terminal Cash Flow in year 5:
The terminal cash flow can be calculated as
Terminal Cash Flow = After-tax Proceeds from Disposal + Working Capital Recouped + operating cash flows
= {Proceeds -(Proceeds Book Value) × Tax Rate} + 7,000 + 264,178
= {95,000 - (95,000 - 41,472) * 40% } + 7,000 +264,178
={95,000 - (53,528) * 40% } + 7,000+ 264,178
={95,000 - 17,411} + 7,000 + 264,178
=348,767
4.What is the firm’s cost of capital? (Show the calculation of each of the three component costs)
cost od debt = annual coupon payment / par value ( 1-floating cost)
= 1000 * 9% / 1000(1-3%)
=90 / 1000 * 0.97 = 90 / 970 = 0.0928 = 9.28% is the cost of debt
cost of preffered stock = dividend per share / par value ( 1-floating cost)
= 100 * 12% / 100(1-5%)
=12 / 100 * 0.95 = 12 / 95 = 12.63% is the cost of preffered stock
cost of common stock = dividend of next year / current price ( 1- floating cost) + growth rate
=2.1 + 8% / 30(1-8%) + 8%
=2.268 / 27.6 + 8% = 8.22 + 8% = 16.22% is the cost of common stock.
Now, let us firm’s cost of capital = weights of debt * cost of debt +weights of preffered stock * cost of preffered stock +weights of common stock * cost of common stock
= 40% * 9.28% + 10% * 12.63% + 50% * 16.22%
=0.03712 + 0.01263 + 0.0811
= 0.13085
=13.1% is the firm's cost of capital
year calculation of depreciation closing balance 0 - 420,000 1 420,000 * 14.29% = 60,018 359,982 2 420,000 * 24.49% = 102,858 257,124 3 420,000 * 17.49% = 73,458 183,666 4 420,000 * 12.49% = 52,458 131,208Related Questions
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