You will use the following case study for this assignment: Kunz, D., & Dow, B.,

Question

You will use the following case study for this assignment: Kunz, D., & Dow, B., III. (2010). Cape Chemical: Capital budgeting issues. Journal of the International Academy for Case Studies, 16(5), 133-137. Case Summary: This case is primarily a capital budgeting expansion project for the company, Cape Chemical, which has done very well in the past in terms of sales and profits growth, and now needs to expand. Furthermore, the sudden withdrawal of one key competitor from the region has opened the opportunity for Cape Chemical to increase its market share. Unfortunately, the company was already operating at its maximum. So, the company needs to expand its work force and storage capacity and acquire more equipment. However, the company has no set process for capital expenditure evaluation in place. The company is unsure whether it should buy used or new equipment. Although the used equipment costs significantly less, it has an economic life of just three years, while the new equipment will last seven years. Your task is to conduct a cash flow analysis for each alternative and provide recommendations to Cape Chemical. This case study has two sections; the first part looks at the weighted average cost of capital (WACC), and the second extends to capital budgeting. For this week, you are required to answer only questions 1-3. Your well-written draft should answer questions 1-3 and meet the following requirements: Be provided in one document in Word or a similar word processing program Provide at least one paragraph of supporting explanation in response to each question Provide an Excel spreadsheet with solutions to each question on a separate worksheet; formulas in the spreadsheet must be linked; each worksheet should be clearly labeled (e.g "Question #1," "Question #2," etc.); and each spreadsheet should be embedded in the Word document.   1. Calculate Cape Chemical’s weighted average cost of capital (WACC). Note: round to the nearest whole number. Discuss the theory used by Clarkson to determine Cape Chemical’s optimum target capital structure (30% debt and 70% equity). 2. Since the used equipment will be financed with internal capital and the new equipment with a bank loan, should the same discount rate be used to evaluate each alternative? Explain. 3. Explain why an accurate WACC is important to a firm's long-term success.

CAPE CHEMICAL: CAPITAL BUDGETING ISSUES David A. Kunz, Southeast Missouri State University Benjamin L. Dow III, Southeast Missouri State University CASE DESCRIPTION The primary subject matter of this case concerns the issues surrounding evaluation of capital expenditures. Case provides a systematic approach to evaluating capital expenditures including a review of alternative capital budgeting methods and the relationship between the cost of capital and capital budgeting. The case requires students to have an advanced knowledge of accounting, finance and general business issues thus the case has a difficulty level of four (senior level) or higher. In particular, an understanding of capital budgeting practices and cost of capital issues is necessary to solve the case. The case is designed to be taught in one class session of approximately 1.25 hours and is expected to require 3-4 hours of preparation time from the students. CASE SYNOPSIS The case tells the story of Ann Stewart, President and primary owner of Cape Chemical. By most measures, the performance of Cape Chemical has been very good over the last three years. Doubledigit sales growth has been achieved, new product lines have been added and profits have more than tripled. The growth has required the acquisition of equipment, expansion of storage capacity and increasing the size of the work force. The unexpected withdrawal of one of Cape Chemical’s competitors from the region has provided the opportunity to increase its blended packaged goods sales. However, Cape Chemical’s blending equipment is already operating at capacity. To take advantage of this opportunity, additional equipment must be obtained, requiring a major capital investment. It is estimated that Cape Chemical must increase its annual blending capacity by 800,000 gallons to meet expected demand for the next three years Annual capacity of 1,400,000 gallons is necessary to meet projected demand beyond the next three years. The firm has no systematic capital expenditure evaluation process. BACKGROUND Cape Chemical is a relatively new regional distributor of liquid and dry chemicals, headquartered in Cape Girardeau, Missouri. The company, founded by Ann Stewart, has been serving southeast Missouri, southern Illinois, northeast Arkansas, western Kentucky and northwest Tennessee for five years and has developed a reputation as a reliable supplier of industrial chemicals. Stewart’s previous 134 Journal of the International Academy for Case Studies, Volume 16, Number 5, 2010 business experience provided her with a solid understanding of the chemical industry and the distribution process. As a general manager for a chemical manufacturer, Stewart had profit and loss (P&L) responsibility, but until beginning Cape Chemical, she had limited exposure to company accounting and finance decisions. The company reported small losses during its early years of operation, but performance in recent years has been very good. Sales have grown at double-digit rates, new product lines have been added and profits have more than tripled. The growth has required the acquisition of additional land, equipment, expansion of storage capacity and more than tripling the size of the work force. Stewart has proven to be an expert marketer, and Cape Chemical has developed a reputation with its customers of providing quality products and superior service at competitive prices. Despite its business success, Cape Chemical is still a “large” small business with Stewart making all important decisions. She recognized the need to develop a professional managerial staff, particularly in the area of finance. Recently, she hired Kate Clarkson as the company’s first finance professional and placed her in charge of the company’s accounting and finance activities. Cape Chemical’s board of directors is composed of Stewart, her brother and the company’s attorney. The board’s existence satisfies state regulatory requirements for corporations but provides no input to business operations. CHEMICAL DISTRIBUTION A chemical distributor is a wholesaler. Operations may vary but a typical distributor purchases chemicals in large quantities (bulk - barge, rail or truckloads) from a number of manufacturers. They store bulk chemicals in "tank farms", a number of tanks surrounded by dikes to prevent pollution in the event of a tank failure. Tanks can receive and ship materials from all modes of transportation. Packaged chemicals are stored in a warehouse. Other distributor activities include blending, repackaging, and shipping in smaller quantities (less than truckload, tote tanks, 55-gallon drums, and other smaller package sizes) to meet the needs of a variety of industrial users. In addition to the tank farm and warehouse, a distributor needs access to specialized delivery equipment (specialized truck transports, and tank rail cars) to meet the handling requirements of different chemicals. A distributor adds value by supplying its customers with the chemicals they need, in the quantities they desire, when they need them. This requires maintaining a sizable inventory and operating efficiently. Distributors usually operate on very thin profit margins. RMA Annual Statement Studies indicates "profit before taxes as a percentage of sales" for Wholesalers - Chemicals and Allied Products (Standard Industrial Code number 5169) is usually in the 3.0% range. In addition to operating efficiently, a successful distributor will possess 1) a solid customer base and 2) supplier contacts and contracts which will ensure a complete product line is available at competitive prices. 135 Journal of the International Academy for Case Studies, Volume 16, Number 5, 2010 THE SITUATION The unexpected withdrawal of one of Cape Chemical’s competitors from the region has provided the opportunity to increase its blended packaged goods sales. That's the good news. The bad news is Cape Chemical’s blending equipment is operating at capacity, thus to take advantage of this opportunity, additional equipment must be obtained, requiring a major capital investment. It is estimated that Cape Chemical must increase its annual blending capacity by 800,000 gallons to meet expected demand for the next three years Annual capacity must increase by 1,400,000 gallons to meet projected demand beyond the next three years. Stewart is considering two alternatives proposed by the company’s engineer. The first is the acquisition and installation of used equipment that will provide the capacity to blend an additional 800,000 gallons annually. The used equipment will cost $105,000 to acquire and $15,000 to install. The equipment is projected to have an estimated life of three years. The second option is the acquisition and installation of new equipment with the capacity to blend 1,600,000 gallons annually. The new equipment would have a substantially higher cost of $360,000 to acquire and $60,000 to install, but have a higher capacity and an economic life of seven years. The new equipment is also more efficient thus the cost of blending is less than the blending cost of the used equipment. Stewart asked Clarkson to lead the evaluation process. Stewart thinks the used equipment could be obtained without a new bank loan. The acquisition of the new equipment would require new bank borrowing. The evaluation of each alternative will require an estimate of the financial benefits associated with each. The marketing and sales staff estimated incremental sales of blended package material will be 600,000 gallons the first year and increase by 15% each year thereafter. During the last year, the average selling price for blended material has been near $4.05 per gallon and material cost (not including a cost for blending the material) has been approximately $3.53. The marketing staff anticipates no significant change in either future selling prices or product costs; however they do estimate variable selling and administrative expenses associated with the increased blended material sales to be $.20 per gallon. PROJECT EVALUATION PROCESS The company has no formal process for evaluating capital expenditure projects. In the past Stewart had reviewed investment alternatives and made the decision based on her “informal” evaluation. Clarkson plans to develop a formal capital budgeting process using the Cash Payback Period, Discounted Cash Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR) evaluation methods. She will need to educate Stewart on the superiority of a formal evaluation process using these methods. 136 Journal of the International Academy for Case Studies, Volume 16, Number 5, 2010 Weighted Average Cost of Capital (WACC) Using input from an investment banking firm, Clarkson estimates the company's cost of equity to be 18%. Their bank has indicated a long-term bank loan can be arranged to finance the new equipment at an annual interest rate of 12% (before tax cost of debt). The bank would require the loan to be secured with the new equipment. The loan agreement would also include a number of restrictive covenants, including a limitation of dividends while the loans are outstanding. While long-term debt is not included in the firm's current capital structure, Clarkson believes a 30% debt, 70% equity capital mix would be appropriate for Cape Chemical. Last year, the company's federal-plus-state income tax rate was 30%. Clarkson does not expect the income tax rate to change in the foreseeable future. Used Equipment The used equipment will cost $105,000 with another $15,000 required to install the equipment. The equipment is projected to have an economic life of three years with a salvage value of $9,000. The equipment will provide the capacity to blend an additional 800,000 gallons annually. The variable blending cost is estimated to be $.20 per gallon. The equipment will be depreciated under the Modified Accelerate Cost Recovery System (MACRS) 3-year class. Under the current tax law, the depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in years 1 through 4, respectively. The increased sales volume will require an additional investment in working capital of 2% of sales (to be on hand at the beginning of the year). New Equipment The acquisition of new equipment with the capacity to blend 1,600,000 gallons annually is the second alternative. The new equipment would cost $360,000 to acquire with an installation cost of $60,000 and have an economic life of seven years and a salvage value of $60,000. The new equipment can be operated more efficiently than the used equipment. The cost to blend a gallon of material is estimated to be $.17. The equipment will be depreciated under the MACRS 7-year class. Under the current tax law, the depreciation allowances are 0.14, 0.25, 0.17, 0.13, 0.09, 0.09, 0.09 and 0.04 in years 1 through 8, respectively. The increased sales volume will require an additional investment in working capital of 2% of sales (to be on hand at the beginning of the year). REQUIREMENTS Assume the role of a consultant, and assist Clarkson to answer the following questions. 137 Journal of the International Academy for Case Studies, Volume 16, Number 5, 2010 1. Calculate Cape Chemical’s weighted average cost of capital (WACC). Note: round to the nearest whole number. Discuss the theory used by Clarkson to determine Cape Chemical’s optimum target capital structure (30% debt and 70% equity). 2. Since the used equipment will be financed with internal capital and the new equipment with a bank loan, should the same discount rate be used to evaluate each alternative? Explain. 3. Explain why an accurate WACC is important to a firm's long-term success.

Explanation / Answer

USED EQUIPMENT: WACC: cost of equity = 18% (given) cost of debt = 12*0.7 = 8.4% WACC = 18*0.7 + 8.4*0.3 = 15.12% USED EQUIPMENT: Initial cash flow: cost of the used equipment 105000 cost of installation 15000 total cost of the new equipment 120000 additional working capital - 2% of 2430000 48600 168600 Yearly operating cash flows: 1 2 3 quantity to be blended in gallons 600000 690000 793500 sales @ $4.05 2430000 2794500 3213675 costs: material cost @ $3.53 2118000 2435700 2801055 ` blending cost @ $0.20 120000 138000 158700 selling & administrative expenses @ $0.2 120000 138000 158700 depreciation expense 39600 54000 18000 total expenses 2397600 2765700 3136455 incremental EBIT 32400 28800 77220 tax at 30% 9720 8640 23166 EBIT(1-t) 22680 20160 54054 add: depreciation 39600 54000 18000 yearly operating cash inflows after tax 62280 74160 136440 increase in working capital @2% 7290 8383 0 net yearly 54990 65776.5 136440 pvif @ 15.12% 0.8687 0.7546 0.6555 2.2787 pv 47768 49633 89431 cumulative pv 186832 Terminal cash flows: salvage value of the equipment 9000 30% tax on gains on sale (9000-8400) -180 recovery of net working-capital 64274 73094 pvif @ 15.12% 0.6555 pv 47910 NPV & EUANPV of the used equipment: pv of yearly cash inflows 186832 pv of terminal cash inflows 47910 pv of cash inflows 234742 less: initial investment 168600 NPV 66142 EUANPV (66142/2.2787) 29026 B) NEW EQUIPMENT: Initial cash flow: cost of the equipment 360000 cost of installation 60000 total cost of the new equipment 420000 additional working capital - 2% of 2430000 48600 468600 Yearly operating cash flows: 1 2 3 4 5 6 7 quantity to be blended in gallons 600000 690000 793500 912525 1049404 1206814 1387836 sales @ $4.05 2430000 2794500 3213675 3695726 4250085 4887598 5620738 costs: material cost @ $3.53 2118000 2435700 2801055 3221213 3704395 4260055 4899063 blending cost @ $0.17 102000 117300 134895 155129 178399 205158 235932 selling & administrative expenses @ $0.2 120000 138000 158700 182505 209881 241363 277567 depreciation expense 58800 105000 71400 54600 37800 37800 37800 total expenses 2398800 2796000 3166050 3613448 4130475 4744376 5450362 incremental EBIT 31200 -1500 47625 82279 119611 143222 170375 tax at 30% 9360 -450 14288 24684 35883 42967 51113 EBIT(1-t) 21840 -1050 33338 57595 83727 100256 119263 add: depreciation 58800 105000 71400 54600 37800 37800 37800 yearly operating cash inflows after tax 80640 103950 184590 288540 473130 761670 1234800 increase in working capital @2% 7290 8383 9641 11087 12750 14663 0 63815 net yearly 73350 95566.5 174949 277453 460379.7 747007.2 1234800 pvif @ 15.12% 0.8687 0.7546 0.6555 0.5694 0.4946 0.4296 0.3732 4.1455 pv 63716 72111 114672 157974 227700 320937 460830 cumulative pv 1417941 DEPRECIATION 0.14 0.25 0.17 0.13 0.09 0.09 0.09 0.04 Terminal cash flows: salvage value of the equipment 60000 30% tax on gains on sale (60000-16800) -12960 recovery of net working-capital 112415 159455 pvif @ 15.12% 0.6555 pv 104517 NPV & EUANPV of the used equipment: pv of yearly cash inflows 1417941 pv of terminal cash inflows 104517 pv of cash inflows 1522458 less: initial investment 468600 NPV 1053858 EUANPV (1053858/4.1455) 254217

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