Liberty Marine Products (LMP) is evaluating its capital budgeting opportunities for the next year. LMP manufactures premium quality ski boats and cruisers in a range of lengths from 22 to 34 feet. This year, they are considering moving into the market for smaller family runabouts with Project S, a 16 foot V hull. Edward Johnson has been assigned to evaluate Project S. Information about other capital budgeting proposals is provided in Exhibit 1.

As LMP traditionally has been a manufacturer of larger boats, the production of a smaller runabout essentially represents a move into a different product market with an increased number of competitors. However, LMP’s technological expertise in larger premium boats has prompted their interest in the production of smaller, more affordable runabouts. As a result of their R&D investment, LMP has developed a new manufacturing process to construct a stronger yet lighter hull to create a smoother, more stable ride with the ability to achieve higher speeds relative to other current offerings. Although the technology is new, LMP is relatively confident that the new technology will have positive applications in the runabout market. Although the new hull has been tested in LMP’s lab, there is naturally some concern about the long-term durability of the hull.

Project S will require capital investment in machinery and equipment of $11,250,000. Installation and training costs will be $75,000. These assets will be depreciated as a 5 year asset in MACRS depreciation. The project has a 6 year expected life. LMP expects to produce and sell 500 of the boats in the first year at a price of $17,000 each. Output is expected to increase at a 5% annual rate. Operating expenses are estimated at $10,600 per unit. The project will require an initial investment in net working capital of $1,250,000. Price, operating costs, and net working capital are all expected to increase at 3% annually. At the end of the project’s life, LMP expects to recover all net working capital and expects to be able to liquidate the capital equipment for $140,000. The company’s marginal tax rate is 30%.

LMP currently employs a capital structure consisting of 30% debt and 70% equity. Edward’s boss, Carl Miller, has asked Edward to review the use of the 30/70 D/E ratio as the target capital structure for the firm. Carl wonders if a 20/80 or a 40/60 ratio might be more appropriate. He suggest to Edward that, as an approximation, the required return on debt will increase by ¾ of a percentage point if the firm moves to the 40/60 ratio and will decline by 1/2 of a percentage point if the firm moves to the 20/80 ratio.

LMP has an outstanding bond issue with14 years to maturity. The semiannual bonds have a 7% coupon and are currently selling for $1,096. LMP’s stock pays a current dividend of $1.30 and is selling for about $16. Edward believes that the firm’s earnings and dividends will grow by about 4% annually for the foreseeable future. LMP’s beta has been estimated at 1.15. Treasury bonds currently yield about 2.0% and the expected return to the S%P 500 is 9.0%.

LMP uses risk-adjusted discount rates in its capital budgeting process. Average-risk projects are discounted at the firm’s weighted average cost of capital. High-risk projects are discounted at this rate plus 3% points and low-risk projects are discounted at this rate minus 2% points.

Edward’s report to Carl Miller needs to specify Project S’s NPV, which other projects LMP should accept, and a recommendation for the optimal target capital structure.  

Exhibit 1

Project             IRR                 Cost                 Risk

X                     11.2%              $3,000,000      High

A                     9.9%               $2,200,000      Average

T                      10.2%             $1,800,000      Average

R                     13.8%              $4,250,000      High

Q                     6.9%               $1,200,000      Low