In January 2020, Mr. Yavuz, chairman and chief executive officer of TCBF faced an

important decision about expanding his food company into a new line of frozen food

products. The proposed $5 million project, Mr. Yavuz thought, would lead to a paradigm

shift for consumers concerned about food safety during the COVID-19 pandemic.

Company Background

Founded in 1975 as a farming business in Carson County, Texas, Mr. Yavuz Sr. entered

the food business mostly by chance in 1988 - when a food company to whom he had sold

produce went into bankruptcy and he received the whole food processing plant as part of

the settlement. From that small beginning, TCBF evolved into one of the largest food

processing companies in the United States in addition to its farming business. By 2020,

the company had over 30 different plants across the country.

Processed Food Industry

TCBF had been phenomenally successful when judged in terms of growth and

profitability (see Exhibit 1). However, the business was not without its risks. There were

two principal sources of risk: supply and demand, both of which were highly uncertain.

With regard to supply, profitability was affected by events beyond the control of

management. Climate change, for example, was making harvest quality and quantity

unpredictable, leading to a volatile cost base. With regard to demand, new trends in

healthy lifestyle habits of consumers and their fickle preferences made seasonal planting

decisions difficult. Also, when there was a new, trendy ingredient from an exotic land,

consumers were quick to switch. Mr. Yavuz still remembered missing out on the quinoa

trend. He was luckier when the avocado trend was in full swing. All in all, the processed

food business had its risks.

Frozen Food Industry

It was difficult to obtain accurate data on sales and profitability of the various

competitors because most of them tended to be local, privately-owned subcontractors.

However, there were six publicly traded companies: Agro Blast, Flash Buds, Green

Thumbs, Healthy Grains, Macro Tastes, and Yummy Veggies. Only Agro Blast and Flash

Buds concentrated in the frozen food industry, while the other four had additional

business segments such as canned and packaged foods. Summary data for these six

companies are shown in Exhibits 2.

Staff had determined that it would cost $5 million to install the machinery necessary to

make frozen food products. If the engineering work started in the first quarter of 2020,

the project could be finished by the beginning of 2021. Staff had also projected that it

would be necessary to invest heavily in advertising and marketing in the early years. The

brand image of a new product was an essential contributor to success.

Pro forma data for the project are shown in Exhibit 3, which assumes that the annual

inflation rate will be 4%. Current operating liabilities of the project were expected to be

9% of total sales. The tax rate on income from the project was expected to be 35% (the

combined U.S. federal and Texas state tax rate). Any losses from the project in the early

years would be used to offset the company's profits. Some data on capital market

conditions are provided below.

Mr. Yavuz thought that the project looked attractive, but was concerned that accepting it

might reduce the company's high rate of return on invested capital.

Please answer the following questions.

1. (a) Based on the Capital Asset Pricing Model, what is the appropriate

weighted average cost of capital for TCBF's investment in the new project to make

frozen food products?

(b) prepare sensitivity analysis for WACC for the following cases:

i. Debt ratio of 0%

ii. Debt ratio of 10%

iii. Debt ratio of 50%

From now on you can assume that the weighted average cost of capital is 14%.

(2) (a) What are the forecasted free cash flows for the project through 2026?

(b) What is the present value of these cash flows?

(3) On the assumption that the project lasts forever with the appropriate

maintenance, what is the terminal value of the project if there is no real growth

beyond 2026? What is the total value of the project?

(4) Conduct an alternate valuation of the project by using the market-to-book

ratio of comparable firms. (Hint: You first need to calculate the market-to-book ratios

for the comparable firms using the data given.)

Selected Capital Markets Data in December 2019

Interest Rate - Long Term AAA 5.2%

Interest Rate - Long Term AA 5.5%

Interest Rate - Long Term A 5.8%

Interest Rate - Long Term BBB 6.1%

Short Term T-Bills 4.8%

Long Term Government Bonds 5.0%

MRP 7.5%