Jack Tar, CFO of Sheetbend & Halyard, Inc., opened the company confidential enve
ID: 2714579 • Letter: J
Question
Jack Tar, CFO of Sheetbend & Halyard, Inc., opened the company confidential envelope. It contained a draft of a competitive bid for a contract to supply duffel canvas to the U.S. Navy. The cover memo from Sheetbend's CEO asked Mr. Tar to review the bid before it was submitted.
The bid and its supporting documents had been prepared by Sheetbend's sales staff. It called for Sheetbend to supply 100,000 yards of duffel canvas per year for 5 years. The proposed selling price was fixed at $35 per yard. Mr. Tar was not usually involved in sales, but this bid was unusual in at least two respects. First, if accepted by the navy, it would commit Sheetbend to a fixed price, long-term contract. Second, producing the duffel canvas would require an investment of $2.8 million to purchase machinery and to refurbish Sheetbend's plant in Pleasantboro, Maine. Mr. Tar set to work and by the end of the week had collected the following facts and assumptions: • The plant in Pleasantboro had been built in the early 1900's and is now idle. The Plant was fully depreciated on Sheetbend's books, except for the purchase cost of the land (in 1947) of $10,000. • Now that the land was valuable shorefront property, Mr. Tar thought the land and the idle plant could be sold, immediately or in the near future, for $600,000. • Refurbishing the plant would cost $800,000. This investment would be depreciated for tax purposes on the 10-year MACRS schedule. • The new machinery would cost $2 Million. This investment could be depreciated on the 5-year MACRS schedule. • The refurbished plant and new machinery would last for many years. However, the remaining market for duffel canvas was small, and it was not clear that additional orders could be obtained once the navy contract was finished. The machinery was custom-built and could be used only for duffel canvas. Its secondhand value at the end of 5 years was probably zero. • The Staff's forecasts of income from the navy contract is detailed below. Mr. Tar reviewed this forecast and decided that its assumptions were reasonable, except that the forecast used book, not tax, depreciation. • But the forecast income statement contained no mention of working capital. Mr. Tar thought that working capital would average about 10% of sales. Armed with this information, Mr. Tar constructed a spreadsheet to calculate the NPV of the duffel canvas project, assuming that Sheetbend's bid would be accepted by the navy. He had just finished debugging the spreadsheet when another confidential envelope arrived from Sheetbend's CEO. It contained a firm offer from a Maine real-estate developer to purchase Sheetbend's Pleasantboro Land and plant for $1.5 million in cash. Mr. Tar had the following information to determine the company's Weighted Average Cost of Capital which he intended to use at the discount rate for this analysis: • Sheetbend's only debt was 10,000, 30 year bonds issued at a price of $950 with a coupon rate of 5%. • Retained Earnings on Sheetbend's balance sheet was $500,000. • Sheetbend had 1,000,000 shares outstanding of company stock currently selling at $15 per share. • Sheetbend's Beta was estimated at .8 • The Risk Free Rate was 2% • The expected return of the Market was 11% Should Mr. Tar recommend submitting the bid to the navy at the proposed price of $35 per year? or Should Mr. Tar recommend the company pursue it's next best alternative? Please prepare a memo to Sheetbend's CEO with a recommendation providing supporting information on all aspects of your analysis.
Notes: 1. Yards sold and price per year would be fixed by contract
2. Cost of Goods includes $300,000 of fixed costs and $18 per yard of variable costs.
3. Costs are expected to increase at an annual inflation rate of 4%
4. The $2 Million of Machinery is depreciated straightline over 5 years ($400,000 per year) and the $800,000 refurbishing of the plant is depreciated straight-line over 10 years ($80,000 per year)
Inflation 4% (000$) 1 2 3 4 5 Units Sold (000) 100 100 100 100 100 Unit Price $35 $35 $35 $35 $35 Revenue $3500 $3500 $3500 $3500 $3500 CostsOfGoodsSold $2100 $2100 $2100 $2100 $2100 Operating Cash Flow $1400 $1400 $1400 $1400 $1400 Depreciation $480 $480 $480 $480 $480 Income $920 $920 $920 $920 $920 Tax @ 35% $322 $322 $322 $322 $322 Net Income After Tax $598 $598 $598 $598 $598Explanation / Answer
Jack Tar, CFO of Sheetbend & Halyard, Inc., opened the company confidential enve
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