Capital investment analysis: roman manufacturing company case study.

Stefano, Giuseppes third grandchild, was now running Roman Manufacturing, while his cousin, Guido, was director of manufacturing operations. Guido presented to Stefano and the other managers his research into the costs of acquiring new machinery for the athletic footwear and casual shoes lines. However, Lorenzo brought forth the possibility of setting up a subsidiary in Southern Italy making a new line of mens and womens luxury shoes. Establishing a new manufacturing branch in Southern Italy caught Stefano totally off-guard, but when Lorenzo, another cousin and the companys chief financial officer, heard that a long-established Italian family was looking to sell their company, House of Napoli Shoes, at a fairly reasonable price, the opportunity presented Stefano with an intriguing possibility he could not ignore. Stefano and Guido had come to the conclusion that Romans manufacturing plant needed ten new machines to make athletic shoes. The cost would be $1.25 million dollars just for the new machinery imported from abroad. Materials and supplies as well as workers salaries and benefits would come to be $1 million. The total cost would be $2.25 million. Roman Manufacturing had the floor-space for the machines and could transition to the new product line in approximately six months. Guido also did research into the machinery needed for the casual footwear line. Roman would need ten new machines, imported from overseas, at a cost of $2 million. The cost of materials and supplies and workers wages would be $1.25 million for a total cost of $3.25 million. These machines would need less floor space than the machines for the athletic footwear and would take approximately four months to start manufacturing operations. The situation with the purchase of the Italian shoe manufacturing company, House of Napoli Shoes, was more complicated. First, the sale would have to be approved by the Italian government and the anti-trust division of the European Union (EU). Once that hurdle was cleared then the unions involved with the company would have to be assured that no jobs would be lost after the sale took place. Stefano knew that the situation regarding the relationship with the unions could hurt Romans reputation in Italy and the United States if it was not handled correctly. Stefano always felt that bad publicity will hurt a good company every time. Guido and Lorenzo had been in negotiations with the Italian firm as well as with the anti-trust division of the EU and the unions. Guido and Lorenzo were able to work out a deal in which Roman would purchase the Italian firm for $500 million. The deal would be all cash and financed by the sale of corporate bonds and common and preferred stock to new and

Financial Information:

Stefano, after consulting with Guido and Lorenzo as well as with Romans accounting firm, investment bankers, and financial advisors came up with three different methods to finance each possible venture. For the casual footwear line, the commercial bank Roman Manufacturing has been working with since the business was purchased by Giuseppe in 1933 could make a loan for $3.25 million at a fixed rate of 5% for a term of 10 years with monthly loan payments of $17,447.90. However, there was a prepayment penalty of 2% of the remaining balance of the loan if it were paid off in the first five years. For financing the athletic shoes line, Stefano, based upon Lorenzos recommendation, was considering using a finance company from Chicago. The loan would be for $2.25 million for 10 years at a rate of 6.5% without any prepayment penalties and at a monthly payment of $14,222.43. The financing for the purchase of the Italian footwear company would be the costliest, more complicated, and, Stefano felt, have the highest amount of risk. The financing would be done using a split of corporate bonds, preferred stock, and issuing a new class of common stock specifically designated for the purchase. Fifty percent of the $500 million purchase would be using callable bonds with a coupon interest rate of 5% at a par value of $1,000 per bond and a term of 30 years. The 250,000 issued bonds would pay interest semi-annually and, with Romans corporate tax rate at 34%, the after-tax interest rate on the issue would be 3.3%. The would have a market price of 103 as a percentage of par. Twenty-five percent of the purchase price would be financed using non-cumulative preferred stock issued with a par value of $100 per share and paying dividends quarterly at a rate of 10%. The cost of capital for the preferred stock issue would be 7%. The other 25% of the cash to be raised would come from the sale of a new class of common stock at a projected price of $25.00 per share, not paying dividends for the first five years of the issue, no voting rights, and 5 million shares authorized to be issued. The investment bankers hired by Roman Manufacturing have projected that its would be 1.25, higher than Stefano and Lorenzo wanted it to be. Also, T-bills are currently at a rate of 3%, while the market return rate is 9%. Another piece of the puzzle, and perhaps the most important, are the cash flows each venture could potentially bring to Roman Manufacturing, assuming a 10% discount rate. Lorenzos staff have come up with the following cash flows:

Year Casual Shoes Athletic Shoes House of Napoli Shoes

1 $500,000 $850,000 $1,000,000

2 $400,000 $850,000 $1,500,000

3 $300,000 $850,000 $2,000,000

4 $500,000 $850,000 $2,500,000

5 $800,000 $850,000 $3,500,000

6 $900,000 $850,000 $4,500,000

7 $1,250,000 $850,000 $5,000,000

8 $1,500,000 $850,000 $5,500,000

9 $1,750,000 $850,000 $6,000,000

10 $2,000,000 $850,000 $6,500,000

While Roman Manufacturing is largely a family-owned company, with the Romano family controlling 51% of the firms voting stock, Stefano knew he would have to present managements final decision to the board of directors. For Stefano, there were still questions and concerns that needed to be addressed which he listed in a memo to Lorenzo and requested an answer in one week.

1. What is the net present value (NPV) for each venture? And based on the principle of mutually exclusivity, which venture(s) should be accepted or rejected?

2. What is the internal rate of return (IRR) for each venture? Given that the companys cost of capital is 10%, which venture(s) should be accepted or rejected?

3. What are the Payback Periods for each venture? Which venture(s) should we accept given the companys cutoff period of three (3) years?

4. By using the Capital Asset Pricing Model (CAPM), find the required return on equity for the purchase of House of Napoli Shoes.

5. Examine the proposed bond issue to be used in the acquisition of House of Napoli Shoes and find its cost of debt using the yield to maturity.

6. Given the weights of the equity portion (both preferred and common stock) and debt in the capital structure for the House of Napoli Shoes venture let me know what is Romans weighted average cost of capital involving the deal.

7. What do you think are the best financial decision rules that should be used in order to make a correct decision for the three possible ventures?

8. Are there any key questions that should be considered? 9. As CFO, which of the three ventures do you think Roman Manufacturing should

Please answer all of question.