I need assistance with Turtuga Case Study FINC 495

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 (Megalops atlanticus). 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 only has 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 Figure 1 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 its inventory 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.

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)

for both projects?

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