Please solve the following case in excel. See below the notes to keep in mind.

Pleasure Craft

• You may safely ignore the R&D investment tax credit if you wish

• The ?debt ratio? of 30% actually reflects the weight of debt

• The $105 bond premium corresponds to a bond face value of $100

• OMIT the assumption of $5m in mandatory renovations in the capital budget

• P. 8: You may safely ignore the Treasury spreads provided in Exhibit 3. We?ll discuss in class.

• Conduct your analysis on an annualbasis

• Omit the Canadian 30% capital cost allowance and instead, assume assets are fully depreciated on a straight-line basis to a $0 salvage value

S w 9B05N010 PLEASURE CRAFT INC. Dan Thompson prepared this case solely to provide material for class discussion. The author does not intend to illustrate either effective or ineffective handling of a managerial situation. The author may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright 2005, Ivey Management Services Version: (A) 2009-10-04 Nancy Cummins was feeling a bit overwhelmed the last few weeks. After having worked at Pleasure Craft (PC) Inc. for only a year, she was selected to be the team leader for a very important project. The company was seriously considering expanding into the production of either outboard motors or front-end loaders, and had asked Cummins's team to prepare a detailed financial analysis of each project and to recommend whether one or both projects should be pursued. Determining initial costs, estimating future cash flows and calculating costs of capital were all very new to Cummins, but with a skilled group of professionals on the team, she strongly felt that together they could make the right decision. BACKGROUND PC, a manufacturer of snowmobiles and personal watercraft (PW), had been operating in Canada for more than 40 years. It manufactured its snowmobiles in Winnipeg, Manitoba, and its PW in Kelowna, British Columbia, and sold them both domestically and internationally. The company had been very successful financially, but the board of directors felt that these two segments were maturing and did not offer strong potential for growth. Also, the company was worried about the future prospects of PW, as many municipalities were beginning to limit the use of PW due to noise complaints, safety concerns and riverbank erosion. PC was considering an expansion of its business. One option was to manufacture small, front-end loaders, which would be sold primarily to construction companies, farmers and ranchers, the military and municipal governments. Although the company felt that this new business would draw upon its existing strengths in small-engine manufacturing, it would be selling to a market in which it had no sales experience. A second option was to manufacture outboard motors. This expansion would allow the company to remain in the leisure craft market and utilize its established selling network. Expansion into front-end loaders or outboard motors would be an expensive undertaking necessitating the construction of a new manufacturing plant. Cummins had been assigned as the team leader of a group of Page 2 9B05N010 engineers, accountants and marketers responsible for investigating these new projects. The team had been named \"Badger\" after the ferocious North American mammal, which was representative of the company's outdoor focus. Undertaking both projects was a possibility, but it would tax the company's capital budget and put great pressure on the company's management. FRONT-END LOADER PROJECT PC would have to build a new factory to manufacture front-end loaders. The facility would have capacity to produce 10,000 units per year. The cost of the land would be $1.5 million, and the building would cost $5.5 million. Equipment costing $10 million would also be needed. It was expected that the building and equipment would be either worn out or obsolete within 15 years, at which time the company would reconsider its options relating to this product line. It was estimated that, at the end of the project's life, the land would be worth $3 million, the building $500,000 and the equipment $400,000 in today's dollars. The building and equipment would have minimal salvage value due to their highly specialized nature. The building would be subject to a capital cost allowance (CCA) rate of 10 per cent and the equipment, a CCA rate of 30 per cent. For tax purposes, the building was amortized separately in its own pool. The equipment was a busy class with numerous asset sales and purchases throughout the year. In addition to property, plant and equipment, additional net working capital (NWC) would be required, which would vary with sales. The NWC turnover ratio for this new operation was expected to be 6:1. Sales were estimated to be 2,850 units in the first year, but were expected to grow at approximately 20 per cent per year for the first five years before leveling out to three per cent growth as the company reached maximum market penetration. Sales of front-end loaders were seasonal and were expected to follow the following pattern: January - March April - June July - September October - December 20% 40% 30% 10% Construction companies, farmers and ranchers would purchase their units through local heavy equipment retailers, who would buy the units from PC at a list price of $21,000. In addition to selling to retailers, PC's sales force would sell directly to its military and municipal clients, who would receive a 15 per cent discount on the list price. PC expected sales to its military and municipal clients to be 50 per cent of total sales, but to fall to 25 per cent in Year 4. The cost of goods sold was expected to be $18,650 per unit. Non-traceable factory costs were expected to be $850,000 per year. An additional $250,000 in annual administration costs related to the new plant would be incurred at head office. Selling this new product would demand the hiring of a national sales manager at $110,000 per year and two regional sales managers (Eastern and Western Canada) at $85,000 each per year, who would be located in the corporate sales office and not at the plant. It was felt that 10 additional sales people at a base salary of $35,000 would be needed to sell this new product. A commission equal to two per cent of unit Page 3 9B05N010 gross profit would be received by the national sales manager, who would distribute it to the two regional sales managers and the individual sales persons depending on how well they met their quotas. To encourage sales to higher margin retail clients, the commission was based on the gross profit margin of the units sold. Although difficult to estimate, it was expected that the company would have enough market power to raise prices by the inflation rate each year. All costs were also expected to increase by the inflation rate, which was estimated to average two per cent per year over the life of the project. Cash flows other than sales and costs of goods sold occurred uniformly throughout the year. OUTBOARD MOTOR PROJECT The new factory to build outboard motors would last approximately 20 years and could produce approximately 30,000 units per year. The land would cost $1.2 million and the building would cost $6.25 million. Production equipment worth $7.5 million would also have to be acquired. It was estimated that, in 20 years, the land would be worth $2.5 million and the building $1.25 million in today's dollars. The equipment would have a negligible salvage value. The building was subject to a CCA rate of 10 per cent and the equipment, a rate of 30 per cent. For tax purposes, the building was amortized separately in its own pool. Additional NWC would be required to support this project. The NWC turnover ratio for this new operation was expected to be 6:1. Sales were estimated to be $10,000 the first year, but would grow at 10 per cent a year until the end of Year 10 at which time, sales were expected to level out. Sales would then grow at three per cent a year reflecting general growth in the industry. Major increments in capacity were not economical due to the nature of the production process, but the company felt production could be increased to as much as 35,000 units with improvements in work methods. Sales of outboard motors were seasonal and were expected to follow the pattern below: January - March April - June July - September October - December 10% 60% 20% 10% Outboard motors would be sold through the same retailers that carried snowmobiles and PWs. The selling price would average $3,500 per unit. The cost of goods sold was expected to be $3,000 per unit. Nontraceable factory costs were expected to be $650,000 per year, and an additional $175,000 in annual administration costs related to the new plant would be incurred at head office. No new sales staff would be required, but sales people would receive a commission equal to one per cent of the gross profit on each unit. It was expected that prices and costs would increase by the inflation rate over the life of this project. To remain up to date with technology, a major overhaul of the product would be required at the end of the 10th year. Research and development (R&D) costs of approximately $100,000 each year would be incurred prior to the introduction of the new model, and a $1 million overhaul of the production process would be undertaken near the end of Year 10. This overhaul could be completed on weekends, and would not interfere with factory production. The new equipment would be in the same CCA class as the other production equipment, and the R&D costs would qualify for a 20 per cent investment tax credit each year. Page 4 9B05N010 COST OF FINANCING In the past, PC had used the treasury spread approach to estimate the cost of its debt and then applied a historical average risk premium to determine the cost of equity (common shares) financing. As the company had become more financially sophisticated, it decided to use the capital asset pricing model (CAPM) for calculating the cost of equity and to determine the cost of debt using the implied rate for bonds or recently negotiated rates for bank loans. When these rates were not available, bonds rates of companies with similar bond rating were used. PC calculated its Beta using monthly return data over a five-year estimating period. Exhibit 1 shows the most recent data used. The six per cent return on the 10-year treasury bond was used as a proxy for the risk-free rate. The market risk premium was calculated using return data for the national stock index and the 10-year treasury bond for 1973-2000. Exhibit 2 shows the current data. Recently, PC did a private placement of a 10-year bond issue with a major life insurance company. The bond had a coupon rate of eight per cent and sold at a premium of $105. PC realized that diversifying into front-end loaders represented a move into a riskier industry. Construction was more cyclical than recreational vehicles and was thus subject to intense foreign competition particularly from many emerging low-wage economies, such as China. Obviously, using the company's current cost of capital would be a mistake. PC was able to identify five companies that produced a similar product. Their debt/equity ratios varied considerably, and two (Henderson and Cramer) were multi-divisional companies that manufactured different products or delivered services in more than one industry (see Exhibit 3). The corporate tax rate was 35 per cent. CAPITAL BUDGET PC had adopted a debt ratio of 30 per cent as its target capital structure, based on a worst-case scenario analysis done by A&G Consulting. PC planned on maintaining this ratio in the future as it attempted to \"grow\" its business through these and other expansion projects. Company policy was to fund all growth with retained earnings and debt. The rationale for this policy was that retained earnings were cheaper than issuing new equity, and the founding family of PC (the Waltersons) desired to maintain control over the business their ownership stake was currently 55 per cent. The company had not issued new equity in more than 20 years, although in some years, it had to delay positive net present value (NPV) projects due to a lack of internally generated equity. Of the current year's capital budget, $5 million was earmarked for mandatory renovations on existing buildings and equipment to comply with health and safety regulations. Pleasure Craft expected to generate approximately $20 million in new equity in the current year. The cost of issuing new equity had been estimated at eight per cent of the funds raised, while the cost of debt was only three per cent. Company policy was to include all issuance costs in the cost of capital. Page 5 9B05N010 DECISION PROBLEMS Cummins, Team Badger leader, had been asked by Jane Meadows, vice-president of operations, to supply an estimate of the costs of capital that were suitable for analysing these two expansion projects. Meadows requested a detailed analysis of how these figures were calculated and their limitations. Meadows also asked that Team Badger complete a detailed evaluation of the two expansion options, calculating cash flows on a quarterly basis. Team Badger was also asked to make a recommendation on which project(s) to select and provide quantitative and non-quantitative rationale for their decision. The NPV approach should be the primary method used, as per company policy, but the internal rate of revenue (IRR) should also be calculated for each project. Page 6 9B05N010 Exhibit 1 CALCULATION OF BETA 2000-2004 Months 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Stock Index 4,834.78 5,100.56 4,789.45 4,900.45 4,901.34 5,265.95 5,560.34 5,660.87 5,500.23 5,798.34 5,900.65 5,927.03 5,803.34 6,034.33 6,100.93 6,378.45 6,456.33 6,409.37 6,543.55 6,698.33 6,703.87 6,684.34 6,834.95 6,999.44 6,584.50 6,593.22 6,534.56 6,667.98 6,490.88 6,389.22 PC Share Price 41.34 44.49 38.23 44.67 47.83 49.78 48.94 53.23 48.64 60.34 63.57 57.34 55.30 58.56 60.20 64.55 65.44 64.32 67.68 70.23 70.78 69.23 72.75 67.45 64.35 65.78 63.45 66.34 62.65 63.67 Month 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 Stock Index 6,289.78 6,305.53 6,310.76 6,450.33 6,477.88 6,485.94 6,432.94 6,600.00 6,734.55 7,321.34 7,454.34 7,645.48 7,903.33 8,134.33 8,234.33 8,305.33 8,300.87 8,413.75 8,500.33 8,700.34 8,654.00 8,778.30 8,503.00 8,876.33 8,903.33 9,034.44 8,953.33 8,957.32 9,003.78 8,933.68 PC Share Price 61.67 62.98 63.33 65.44 66.56 68.34 65.78 67.57 68.34 74.99 76.54 79.67 73.44 78.34 81.23 83.33 83.45 85.66 86.55 91.00 89.03 91.33 89.33 93.44 94.34 95.87 94.34 95.43 95.34 94.33 Page 7 9B05N010 Exhibit 2 STOCK AND BOND INDEXES 1973-2000 Year 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Stock Index 1,208 886 974 1,012 1,060 1,310 1,813 2,269 1,954 1,985 2,552 2,400 2,900 3,066 3,160 3,390 3,969 3,257 2,512 2,350 3,201 4,213 4,714 5,927 6,999 6,486 8,414 8,933 Bond Index 1,040 1,030 1,100 1,174 1,199 1,245 1,320 1,390 1,420 1,480 1,548 1,603 1,700 1,732 1,808 1,900 2,010 2,020 2,038 2,098 2,294 2,384 2,444 2,600 2,793 2,700 2,905 3,145 Page 8 9B05N010 Exhibit 3 COMPANIES PRODUCING SIMILAR PRODUCTS (35 per cent corporate tax rate) Beta Henderson Engines Cramer Equipment Komatsa Machinery James Deer Salamander 1.41 1.62 1.50 1.65 1.30 Equipment Division Treasury Spread (%) 2.29% 2.69% 2.35% 2.74% 2.20% Debt/Equity Ratio 0.34 0.43 0.36 0.50 0.28 Auto Parts Division Oil Field Services Division Accounting Beta Est. Market Value Accounting Beta Est. Market Value Accounting Beta Est. Market Value 1.53 $12.4 m 1.23 $8.5 m 1.45 $2.3 m Henderson Engines Equipment Division Cramer Equipment Specialty Steel Division Accounting Beta Est. Market Value Accounting Beta Est. Market Value 1.41 $8.5 million 1.81 $9.3 million