Precision Putters Inc. Precision Putters Inc. is a manufacturer of high quality

Question

Precision Putters Inc.

            Precision Putters Inc. is a manufacturer of high quality putters for the golfing industry. The company was started eight years ago by Jake Johnson. Jake was an avid golfer with a background in the metalworking industry. As a hobby, he started making putters for himself and some of his friends. As he and some other users of his putters had some success in local amateur tournaments, the reputation and demand for his putters increased. He soon found that he was getting enough requests for his putters that he quit his job at a machine shop and formed Precision Putters Inc. He started his operation with a couple of pieces of machinery in his garage. However, within two years, business was good enough that he moved his operations to a 30,000 square foot manufacturing facility.

The company now sells its putters worldwide and several professional players have won tournaments using Precision Putters (which has obviously helped to boost demand).

            The management of Precision Putters is currently evaluating the purchase of a new high-speed computerized grinding machine to replace its existing grinding machine.

Sally Smith, a recent Geneseo Business School graduate who is now working at Precision Putters as a financial analyst, must analyze this project and present her findings to the company’s executive committee.

            The new machine costs $710,000 and shipping and installation cost would total $10,000. In addition, installation of the new equipment would cause Precision Putters’ inventories to increase by $6,500, accounts receivable to increase by $4,000, and accounts payable to increase by $3,500. The company plans on using the new machine for 5 years. The new machine would be depreciated under MACRS using a 5-year recovery period. It is expected that the new machine can be sold for $95,000 at the end of 5 years.

            The existing machine can be sold currently for $112,000 before taxes. It is 4 years old, cost $420,000 new, and is being depreciated as a 7-year class asset under MACRS. It is expected that the existing machine can be sold for $10,000 at the end of 5 years.

            The new machine is expected to generate $385,000 in profits before depreciation and taxes for each of the next 5 years. The existing machine is expected to generate $190,000 in profits before depreciation and taxes for each of the next 5 years. The firm is subject to a 40% tax rate on both ordinary income and capital gains.

            The section of the building where the new piece of equipment would be installed has been unused for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, the company spent $30,000 to rehabilitate that section of the building. Jake Johnson is not sure but thinks that maybe this outlay, which has already been paid and expensed for tax purposes, should be charged to this new equipment project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $30,000 to make the site suitable for the new equipment.

            Precision Putters has a target capital structure of 40% debt, 10% preferred stock, and 50% common equity. The investment banker believes that 10 year, 9% coupon, $1,000 par value bonds could currently be sold, with a flotation cost of 3% of par value. The firm could sell, at par, $100 preferred stock which pays a 12% annual dividend, and flotation costs of $5.00 per share would be incurred. The company’s common stock has experienced a constant dividend growth rate of 8%, and the company recently paid a dividend of $2.10. The stock is currently selling for $30.00 per share. Any new common stock issued would incur an 8% flotation cost. Management assumes that all new projects will require the issuance of new common stock, and the firm’s weighted average cost of capital to should be used to evaluate the project.

            Sally was asked to analyze the project, and then present her findings to the company’s executive committee. Since some members of the executive committee have a very limited knowledge of capital budgeting techniques, Sally wants to help to educate them. Therefore, she has decided to ask and then answer a series of questions as set forth below.

Questions

1.Should the money that was spent to rehabilitate the plant last year be included in the analysis? Explain.

2.What is Precision Putters’ net initial investment for this project (Year 0 net cash flow)?

3.Define incremental cash flow, and then set forth the project’s operating cash flow statement for each year of operations. What is the expected non-operating terminal cash flow when the project is terminated at Year 5?

4.What is the firm’s cost of capital? (Show the calculation of each of the three component costs)

5.What is the project’s NPV? (Remember to analyze the project’s relevant incremental cash flows including the terminal cash flow in year 5) Explain the economic rationale behind the NPV.

6.What is the project’s IRR? Explain the rational for using the IRR to evaluate projects. Which of the two methods (NPV and IRR) is theoretically superior and why?

7.What is the project’s payback period? What is the rationale behind the use of payback period as an evaluation tool? What are some drawbacks with this method?

8.What overall recommendation would you make regarding this project?

Explanation / Answer

1) The money already spent is a sunk cost and hence need not be considered. 2) INITIAL INVESTMENT: cost of new machine 710000 installation costs 10000    total cost of new machine 720000 increase in net working capital 7000 sale of old equipment 112000 tax 40% on 131195-112000 7678 net proceeds of sale of old equipment 104322                Net initital cash outflow 622678 3) OPERATING CASH FLOWS: 1 2 3 4 5 Operating cash flow--new machine: EBITDA 385000 385000 385000 385000 385000 depreciation 144000 230400 138240 82944 82944 operating income before tax 241000 154600 246760 302056 302056 40% tax 96400 61840 98704 120822 120822 operating income after tax 144600 92760 148056 181234 181234 add: depreciation 144000 230400 138240 82944 82944 operating cash flows after tax 288600 323160 286296 264178 264178 Operating cash flows-Old machine: EBITDA 190000 190000 190000 190000 190000 depreciation 37484 37484 37484 18742 0 operating income before tax 152516 152516 152516 171258 190000 40% tax 61006 61006 61006 68503 76000 operating income after tax 91510 91510 91510 102755 114000 add: depreciation 37484 37484 37484 18742 0 operating cash flows after tax 128994 128994 128994 121497 114000 Incremental OCF after tax 159606 194166 157302 142681 150178 TERMINAL CASH FLOWS: salvage value of new machine 95000 tax 40% on 95000-41472 21411 73589 salvage value lost on old machine 10000 tax @ 40% 4000 net salvage value lost on old machine -6000 release of net working capital 7000      Net after tax terminal cash flows 74589 4) Cost of Capital: Cost of equity Ke using dividend growth model = [(2.1*1.08)/(30-2.4)} +0.08 = 0.1621739 or 16.22% Cost of preferred capital Kp = 12/95 = 12.63% Cost of Debt Kd = 90*0.6/1070 = 5.57% WACC = 0.4*5.57+0.1*12.63+0.5*16.22 = 11.60 % 5) NPV: incrementaal operating cash flows 159606 194166 157302 142681 150178 pvif at 11.6% 0.8960573 0.8029188 0.7194613 0.6446786 0.577669 pv 143016 155900 113173 91983 86753 cumulative pv 590826 pv of terminal cash flow = 74589*0.577669 43088 total pv of cash inflows 633913 less: initial investment 622678 NPV 11235 Since the NPV is positive the project can be undertaken. The rationality of positive NPV is that it gives the absolute addition to the present worth of the shareholders' if the project is undertaken. 6) IRR: cumulative Cash inflows - operating 159606 194166 157302 142681 150178                                 terminal 74589 Net yearly cash inflows 159606 194166 157302 142681 224766 pvif @ 15% 0.8695652 0.7561437 0.6575162 0.5717532 0.4971767 pv 138788 146818 103429 81578 111749 582362 IRR = 15 - (622678-582362)*3.4/(633913-582362) 12.34 % If IRR is > cost of capital the project is acceptable. In this case IRR is 12.34% and cost of capital is 11.6% So the project can be accepted. The justification is that if the projects internal return is greater than the cost of capital it would leave something extra for the shareholders. NPV is superior, because it gives the absolute addition to shareholders' wealth. The IRR is a rate and is susceptible to irregularities like multiple rates, differential ranking etc. 7) Payback period: cumulative cash flows 159606 353773 511075 653756 803934 Initial investment 622678 payback = 3 + (622678-511075)/142681 3.8 years 8) As the NPV is positive the project can be undertaken.

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