Capital Budgeting Case

Spring 2017

Version 1

Viking Freight Forwarding

Viking Freight Forwarding was formerly a family run operation but since 2010 has been publicly traded. It is still controlled by the Ostrem family which owns 60% of the common stock. Jim and Joe Ostrem and sister Kate make up the upper level management team. Tom Bertram, son-in-law of the youngest Ostrem brother, has been hired as the financial vice president of the firm. His primary duties are to evaluate capital budgeting projects and other related long term projects of the operation.

Up to this point long term capital projects were chosen without any formal process of determining the cost of capital for the firm and the returns generated by the projects that were chosen. Bertram was hired mainly because of some major problems with some of the projects over the last few years and some concerns expressed by the minority owners on inadequate decision making on these failed projects.

Bertram is currently undertaking an analysis of five major capital budgeting projects for the coming year. All the projects except for the Ankeny Satellite Terminal project would have the same level of risk as the other long term assets of the firm. Descriptions of the five projects are below and estimate of expected cash flows for each project is outlined in Table 4.

Project 1245-A: Expansion of existing facilities at Des Moines Terminal.

Viking Freight Forwarding operates primarily as a bonded freight forwarder, and thus must provide rapid delivery, on short notice, of freight temporarily stored in its bonded warehouse located on Guthrie Avenue on Des Moines eastside. The terminal has six existing loading docks and this number is often insufficient for the amount of freight that must be forwarded for prompt delivery.

Because of growth in business, Viking has been unable to meet the needs of its customers on several occasions because of backlogs at the loading docks. Firms have begun using other freight forwarders in the area and are starting to have an effect on the revenues of the firm.

Project 1245-A calls for the building of an annex to the existing warehouse; the annex would provide 3 new loading docks and 5,000 square feet of additional storage space. This would take some time to construct and the amount of lost revenues would continue to mount so that the recouping the lost revenues would be spread out over a longer time period. However, the additional storage space would allow for more growth in the future.

Project 1245-B: Alternative expansion of existing facilities at Des Moines Terminal.

Project 1245-B is to simply add 3 additional loading docks to the existing building. This would significantly reduce the construction time relative to project a so that lost revenues could be recouped faster. However, no additional storage space would be added. Project 1245-B would disrupt the current operation more and the warehouse layout would have to be reconfigured, so that the total cost of the project would be the same as Project 1245-A. While the cash inflows would be more rapid, the projects life would be much shorter. This solves the immediate problem but does not address the growth issue.

Project 1245-C: Build a new satellite terminal in Ankeny

Rather than expanding at the current Guthrie Avenue location, Bertram is considering building a satellite terminal in the industrial park in Ankeny which is located 6 miles from the current location. The current site in Des Moines does not have the potential for extensive expansion so he is considering this expansion in an off-site location. This is a much more expensive project and more risky in that excess capacity will be built and coordinating shipments will be more difficult. The cost of capital used on this project would be 1% higher than for an average project.

Project 1248-A: Purchase of Three New Tractor-Trailers.

An increase in business has not only caused backlogs at the loading docks but also has forced Viking to lease tractor-trailers since they have insufficient quantity of their own. This increases the cost of transportation as well as making it difficult to do regularly scheduled maintenance on their tractor-trailers since they are being fully utilized with little down time. Project 1248-A would alleviate this problem.

Project 1257-A: Special equipment for handling bulk commodities.

A profitable capital investment made in 1990 to handle bulk commodities and forward them by rail would be upgraded under Project 1257-A. This would involve the installation of a movable conveyor belt to increase rail car loading efficiency by reducing current labor costs.

Cost of capital considerations:

At the present time, no cost of capital has been determined for use in the capital budgeting process. As a starting point Bertram believes he needs to use the CAPM as the basis for the cost(%) of common equity coupled with the relevant cost(%) of long term debt as noted in the financial statements of the company. While current short term and long term debt rates are at historic lows, Bertram believes that rates will soon return to more normal average rates and should be used in constructing the CAPM.

For simplicitys sake, he has decided to use book value instead of market value to determine the weights for the cost of capital used in the capital budgeting analysis. Table 1 contains the monthly adjusted closing prices for VFF and the S&P 500 and Table 2 contains Ibbotson Index of historical returns for use in constructing the equity cost from the CAPM. Table 3 contains the most current balance sheet for Viking Freight forwarding.

Table #1

Adj Close -VKF

Adj Close - S & P 500

Date

3/2/2016

77.75

2079.43

2/2/2016

78.12

2104.5

1/2/2016

70.12

1994.99

12/1/2015

77.64

2058.9

11/3/2015

81.04

2067.56

10/1/2015

72.87

2018.05

9/2/2015

70.64

1972.29

8/1/2015

66.67

2003.37

7/1/2015

63.48

1930.67

6/2/2015

63.68

1960.23

5/1/2015

63.96

1923.57

4/1/2015

60.63

1883.95

3/3/2015

56.74

1872.34

2/3/2015

53.24

1859.45

1/2/2015

54.24

1782.59

12/2/2014

53.02

1848.36

11/1/2014

51.53

1805.81

10/1/2014

46.9

1756.54

9/3/2014

45.99

1681.55

8/1/2014

43.42

1632.97

7/1/2014

43.68

1685.73

6/3/2014

41.62

1606.28

5/1/2014

43.06

1630.74

4/1/2014

41.50

1597.57

3/1/2014

39.20

1569.19

2/1/2014

39.98

1514.68

1/2/2014

37.28

1498.11

12/3/2013

34.28

1426.19

11/1/2013

33.74

1416.18

10/1/2013

33.58

1412.16

9/4/2013

30.15

1440.67

8/1/2013

29.85

1406.58

7/2/2013

28.27

1379.32

6/1/2013

28.86

1362.16

5/1/2013

28.04

1310.33

4/2/2013

29.65

1397.91

3/1/2013

31.78

1408.47

Table 2. Ibbotson Index Series: Summary Statistics of Annual

Total Return, 19262015s

Geometric Arithmetic Standard

Mean Mean Deviation

Large Company Stocks 10.3% 11.5% 20.4%

Small Company Stocks 12.115.8 32.6

Long-Term Corporate Bonds 5.9 6.2 8.3

Long-Term Government Bonds 5.5 5.9 9.5

Int..-Term Government Bonds 5.4 5.5 5.7

U.S. Treasury Bills 3.3 3.7 3.1

Source: Ibbotson SBBI, 2013Classic Yearbook: Market Results for Stocks, Bonds, Bills,

and Inflation, 19262012(Chicago: Morningstar, 2013

Table 3- Balance Sheet

Viking Freight Forwarding

Balance Sheets

December 30,

2016

December 31,

2015

ASSETS

Current assets:

Cash and cash equivalents

$

2,928

$

4,053

Accounts receivable, net

125,080

90,567

Prepaid expenses

13,805

7,849

Deferred tax asset

8,738

4,048

Other current assets

10,380

3,858

Total current assets

160,931

110,375

Property and equipment, net

179,782

125,892

Goodwill

102,320

31,344

Intangibles, net

38,752

18,471

Non-current deferred tax asset

18,682

Other assets

12,584

16,313

Total assets

$

513,051

$

302,395

LIABILITIES AND SHAREHOLDERS DEFICIT

Current liabilities:

Current maturities of indebtedness

$

4,264

$

4,139

Current maturities of capital lease obligations

4,507

5,261

Accounts payable

43,301

37,571

Independent affiliates and independent owner-operators payable

88,601

79,795

Accrued expenses

46,710

25,327

Environmental liabilities

4,740

3,878

Accrued loss and damage claims

6,806

8,614

Total current liabilities

198,929

164,585

Long-term indebtedness, less current maturities

163,721

93,823

Total liabilities

362,650

258,408

Commitments and contingenciesNote 13

SHAREHOLDERS EQUITY

Common stock, no par value;

70,000

35,000

Retained Earnings

80,401

8,987

Total shareholders equity

150,401

43,987

Total liabilities and shareholders deficit

$

513,051

$

302,395

The accompanying notes are an integral part of these consolidated financial statements.

Long Term Debt:

5.875% Senior Secured Notes due 2021 (2018 Notes)

Table 4

Mutually

Exclusive

Independent

Independent

Project

Project

Project

Project

Project

1245-A

1245-B

1245-C

1248-A

1257-A

CF0

$(785,000.00)

$(990,000.00)

$(3,400,000.00)

$(1,800,000.00)

$(855,000.00)

year

Cash inflows

Cash inflows

Cash inflows

Cash inflows

Cash inflows

1

$ 205,000.00

$ 245,000.00

$ 485,000.00

$ 460,900.00

$ 211,900.00

2

$ 200,000.00

$ 315,000.00

$ 550,000.00

$ 460,900.00

$ 240,900.00

3

$ 210,500.00

$ 330,900.00

$ 610,000.00

$ 465,900.00

$ 241,900.00

4

$ 216,500.00

$ 280,000.00

$ 750,000.00

$ 465,900.00

$ 211,900.00

5

$ 219,400.00

$ 190,000.00

$ 785,000.00

$ 470,900.00

$ 173,900.00

6

$ 269,400.00

$ 80,000.00

$ 800,000.00

$ 458,900.00

7

$ 80,000.00

$ 925,000.00

$ 440,900.00

8

$ 80,000.00

$ 585,000.00

$ 420,900.00

9

$ 408,900.00

10

$ 358,900.00

Note all cash-flows are on an after-tax basis.

1. Compute the weighted average cost of capital for the firm given the current capital structure and after computing the relevant costs.

2. Simply, without consideration for the life of the projects, calculate Payback, NPV, IRR, PI and MIRR for each project using the current cost of capital, note that the Ankeny proposal is riskier. Assume the reinvestment rate for MIRR is the weighted average cost of capital for the firm.

3. Based on your computations in requirement number two, which projects should be accepted? Note: Projects 1245-A, 1245-B and 1245-C are mutually exclusive.

4. Since Projects 1245-A, 1245-B and 1245-C are mutually exclusive and have unequal lives it is appropriate to use other techniques to evaluate the projects. Use the equivalent annuity approach and the replacement chain approach as better techniques for evaluating these three projects. Does this change your decision?

.