BUSN 6021: Corporate Finance

Case Study 3: Cost of Capital and Capital

Budgeting
Pleasure Craft Inc.
NancyCumminshasbeenfeelingabitoverwhelmedinthelastfewweeks.Having
workedatPleasureCraft(PC)Inc.foronlyayear,shewasselectedtobetheteam
leaderforaveryimportantproject.Thecompanyisseriouslyconsideringexpanding
intotheproductionofeitheroutboardmotorsorfrontendloadersandhasasked
Cumminsteamtoprepareadetailedfinancialanalysisofeachprojectandto
recommendwhetheroneorbothprojectsshouldbepursued.Determininginitial
costs,estimatingfuturecashflows,andcalculatingcostsofcapitalareallverynew
toCummins,butwithaskilledgroupofprofessionalsontheteam,shestronglyfeels
thattogethertheycanmaketherightdecision.

Background
PleasureCraft,amanufacturerofsnowmobilesandpersonalwatercraft(PW),has
beenoperatinginCanadaformorethan40years.Itmanufacturessnowmobilesin
Winnipeg,Manitoba,andpersonalwatercraftinKelowna,BritishColumbia,and
sellsthembothdomesticallyandinternationally.Thecompanyhasbeenvery
successfulfinancially,buttheboardofdirectorsfeelsthatthesetwosegmentsare
maturinganddonotofferstrongpotentialforgrowth.Also,thecompanyisworried
aboutthefutureprospectsofpersonalwatercraft,asmanymunicipalitiesare
beginningtolimittheiruseduetonoisecomplaints,safetyconcerns,andriverbank
erosion.
Thecompanyisconsideringanexpansionofitsbusiness.Oneoptionisto
manufacturesmallfrontendloaders,whichwouldbesoldprimarilytoconstruction
companies,farmersandranchers,themilitary,andmunicipalgovernments.
Althoughthecompanyfeelsthisnewbusinesswoulddrawuponitsexisting
strengthsinsmallenginemanufacturing,itwouldbesellingtoamarketinwhichit
hasnosalesexperience.
Asecondoptionistomanufactureoutboardmotors.Thisexpansionwouldallow
thecompanytoremainintheleisurecraftmarketandutilizeitsestablishedselling
network.
Expansionintofrontendloadersoroutboardmotorswouldbeanexpensive
undertaking,necessitatingtheconstructionofanewmanufacturingplant.Cummins
hasbeenassignedastheteamleaderofagroupofengineers,accountants,and
marketersresponsibleforinvestigatingthesenewprojects.Theteamhasbeen

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Case Study 3: Cost of Capital and Capital Budgeting

namedBadgeraftertheferociousNorthAmericanmammal,whichis
representativeofthecompanysoutdoorfocus.
Undertakingbothprojectsisapossibility,butitwouldstrainthecompanyscapital
budgetandputgreatpressureonthecompanysmanagement.

Front-End Loader Project

PleasureCraftwouldhavetobuildanewfactorytomanufacturefrontendloaders.
Thefacilitywouldhavecapacitytoproduce10,000unitsperyear.Thecostofthe
landwouldbe$1.5million,andthebuildingwouldcost$5.5million.Equipment
costing$10millionwouldalsobeneeded.Itisexpectedthatthebuildingand
equipmentwouldbeeitherwornoutorobsoletewithin15years,atwhichtimethe
companywouldreconsideritsoptionsrelatingtoitsproductline.Itsestimatedthat
attheendoftheprojectslife,thelandwouldbeworth$3million,thebuilding
$500,000.00,andtheequipment$400,000.00intodaysdollars.Thebuildingand
equipmentwouldhaveminimalsalvagevalueduetotheirhighlyspecialized
nature.Thebuildingwouldbesubjecttoacapitalcostallowance(CCA)rateof10
percent;theequipmentwouldbesubjecttoaCCArateof30percent.Fortax
purposes,thebuildingwouldbeamortizedseparatelyinitsownpool.The
equipmentisinabusyclasswithnumerousassetsalesandpurchasesthroughout
theyear.
Inadditiontoproperty,plant,andequipment,additionalnetworkingcapital
(NWC)wouldberequiredwhichwouldvarywithsales.TheNWCturnoverratio
forthisnewoperationisexpectedtobe6:1.
Salesareestimatedtobe2,850unitsinthefirstyearbutareexpectedtogrowat
approximately20percentperyearforthefirstfiveyearsbeforelevellingoutto
threepercentgrowthasthecompanyreachesmaximummarketpenetration.Sales
offrontendloadersareseasonalandexpectedtofollowthefollowingpattern:
JanuaryMarch

20 %

AprilJune

40 %

JulySeptember

30 %

OctoberDecember

10 %

Constructioncompanies,farmers,andrancherswouldpurchasetheirunitsthrough
localheavyequipmentretailers,whowouldbuytheunitsfromPleasureCraftata
listpriceof$21,000.00.Inadditiontosellingtoretailers,thecompanyssalesforce
wouldselldirectlytoitsmilitaryandmunicipalclients,whowouldreceivea

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BUSN 6021: Corporate Finance

15percentdiscountonthelistprice.Thecompanyexpectssalestoitsmilitaryand
municipalclientstobe50percentoftotalsales,butfallto25percentinYear4.
Thecostofgoodssoldisexpectedtobe$18,650.00perunit.Nontraceablefactory
costsareexpectedtobe$850,000.00peryear.Anadditional$250,000.00in
administrationcostsrelatedtothenewplantwouldbeincurredatheadoffice.
Sellingthisnewproductwoulddemandthehiringofanationalsalesmanagerat
$110,000.00peryearandtworegionalsalesmanagers(forEasternandWestern
Canada)at$85,000.00eachperyear.Thesemanagerswouldbelocatedinthe
corporatesalesofficeandnotattheplant.Itisfeltthat10additionalsalespeopleata
basesalaryof$35,000.00wouldbeneededtosellthisnewproduct.Acommission
equaltotwopercentofunitgrossprofitwouldbereceivedbythenationalsales
manager,whowoulddistributeittothetworegionalsalesmanagersandthe
individualsalespersons,dependingonhowwelltheymeettheirquotas.To
encouragesalestohighermarginretailclients,thecommissionwouldbebasedon
thegrossprofitmarginoftheunitssold.
Althoughitisdifficulttoestimate,itisexpectedthatthecompanywouldhave
enoughmarketpowertoraisepricesbytheinflationrateeachyear.Allcostsarealso
expectedtoincreasebytheinflationrate,whichisestimatedtoaveragetwopercent
peryearoverthelifeoftheproject.Cashflowsotherthansalesandcostsofgoods
soldoccuruniformlythroughouttheyear.

Outboard Motor Project

Anewfactorytobuildoutboardmotorswouldlastapproximately20yearsand
couldproduceapproximately30,000unitsperyear.Thelandwouldcost$1.2million
andthebuildingwouldcost$6.25million.Productionequipmentworth$7.5million
wouldalsohavetobeacquired.Itisestimatedthatin20yearsthelandwouldbe
worth$2.5millionandthebuilding$1.25millionintodaysdollars.Theequipment
wouldhaveanegligiblesalvagevalue.ThebuildingissubjecttoaCCArateof
10percent;theequipmenthasaCCArateof30percent.Fortaxpurposes,the
buildingisamortizedseparatelyinitsownpool.
Additionalnetworkingcapitalwouldberequiredtosupportthisproject.TheNWC
turnoverratioforthisnewoperationisexpectedtobe6:1.
Salesareestimatedtobe10,000thefirstyear,butwillgrowat10percentperyear
untiltheendofYear10,atwhichtimesalesareexpectedtolevelout.Saleswould
thengrowatthreepercentperyear,reflectinggeneralgrowthintheindustry.Major
incrementsincapacityarenoteconomicalduetothenatureoftheproduction
process,butthecompanyfeelsproductioncouldbeincreasedtoasmanyas35,000

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Case Study 3: Cost of Capital and Capital Budgeting

unitswithimprovementsinworkmethods.Salesofoutboardmotorsareseasonal
andexpectedtofollowthepatternbelow:
JanuaryMarch

10 %

AprilJune

60 %

JulySeptember

20 %

OctoberDecember

10 %

Outboardmotorswouldbesoldthroughthesameretailersthatcarrysnowmobiles
andpersonalwatercraft.Thesellingpricewouldaverage$3,500.00perunit.Thecost
ofgoodssoldisexpectedtobe$3,000.00perunit.Nontraceablefactorycostsare
expectedtobe$650,000.00peryear,andanadditional$175,000.00inadministration
costsrelatedtothenewplantwouldbeincurredatheadoffice.Nonewsalesstaff
willberequired,butsalespeoplewillreceiveacommissionequaltoonepercentof
thegrossprofitoneachunit.Itisexpectedthatpricesandcostswouldincreaseby
theinflationrateoverthelifeofthisproject.
Toremainuptodatewithtechnology,amajoroverhauloftheproductwouldbe
requiredattheendofthetenthyear.Researchanddevelopment(R&D)costsof
approximately$100,000.00eachyearwouldbeincurredpriortotheintroductionof
thenewmodel,anda$1millionoverhauloftheproductionprocesswouldbe
undertakenneartheendofYear10.Thisoverhaulcouldbecompletedonweekends,
andwouldnotinterferewithfactoryproduction.Thenewequipmentwouldbein
thesameCCAclassastheotherproductionequipment,andtheR&Dcostswould
qualifyfora20percentinvestmenttaxcrediteachyear.

Cost of Financing
Inthepast,PleasureCrafthasusedthetreasuryspreadapproachtoestimatethecost
ofitsdebtandthenappliedanhistoricalaverageriskpremiumtodeterminethecost
ofequity(commonshares)financing.Asthecompanyhasbecomemorefinancially
sophisticated,itdecidedtousethecapitalassetpricingmodel(CAPM)for
calculatingthecostofequity,andtodeterminethecostofdebtusingtheimplied
rateforbondsorrecentlynegotiatedratesforbankloans.Whenthesearenot
available,bondratesofcompanieswithsimilarbondratingareused.
PleasureCraftcalculateditsbetausingmonthlyreturndataoverafiveyear
estimatingperiod.Exhibit1showsthemostrecentdataused.The6percentreturn
onthe10yeartreasurybondwasusedasaproxyfortheriskfreerate.Themarket
riskpremiumwascalculatedusingreturndataforthenationalstockindexandthe
10yeartreasurybondfor19732000.Exhibit2showsthecurrentdata.

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BUSN 6021: Corporate Finance

Recently,thecompanydidaprivateplacementofa10yearbondissuewithamajor
lifeinsurancecompany.Thebondhadacouponrateof8percentandsoldata
premiumat$105.00.
PleasureCraftrealizesthatdiversifyingintofrontendloadersrepresentsamove
intoariskierindustry.Constructionismorecyclicalthanthemarketforrecreational
vehiclesandissubjecttofairlyintenseforeigncompetition,particularlyfrommany
emerginglowwageeconomiessuchasChina.Obviously,usingthecompanys
currentcostofcapitalwouldbeamistake.
PleasureCraftwasabletoidentifyfivecompaniesthatproducedasimilarproduct.
Theirdebt/equityratiosvariedconsiderably,andtwo(HendersonandCramer)
weremultidivisionalcompaniesthatmanufactureddifferentproductsordelivered
servicesinmorethanoneindustry.Datacollectedforthesecompaniesincluded:
Beta

Treasury
Spread (%)

Debt/Equity
Ratio

Henderson Engines

1.41

2.29 %

0.34

Cramer Equipment

1.62

2.69 %

0.43

Komatsa Machinery

1.50

2.35 %

0.36

James Deer

1.65

2.74 %

0.50

Salimander

1.30

2.20 %

0.28

Equipment Division

Auto Parts Division

Oil Field Services

Division

Accounting
Beta

Estimated
Market
Value

Accounting
Beta

Estimated
Market
Value

Accounting
Beta

Estimated
Market
Value

1.53

$12.4 m

1.23

$8.5 m

1.45

$2.3 m

Henderson
Engines

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Case Study 3: Cost of Capital and Capital Budgeting

Equipment Division

Specialty Steel Division

Accounting Estimated Accounting Estimated

Beta
Market
Beta
Market
Value
Value
Cramer Equipment

1.41

$8.5 m

1.81

$9.3 m

Thecorporatetaxratewas35percent.

Capital Budget
PleasureCraftadoptedadebtratioof30percentasitstargetcapitalstructure,based
onaworstcasescenarioanalysisdonebyA&GConsulting.Thecompanyplansto
maintainthisratiointhefutureasitattemptstogrowitsbusinessthroughtheseand
otherexpansionprojects.
Companypolicyistofundallgrowthwithretainedearningsanddebt.Therationale
forthispolicyisthatretainedearningsarecheaperthanissuingnewequity,andthe
foundingfamily(theWaltersons)wishestomaintaincontroloverthebusiness
theirownershipstakeiscurrently55percent.Thecompanyhadnotissuednew
equityinmorethan20years,althoughinsomeyearsithadtodelaypositivenet
presentvalue(NPV)projectsduetoalackofinternallygeneratedequity.
Ofthecurrentyearscapitalbudget,$5millionisearmarkedformandatory
renovationstoexistingbuildingsandequipmenttocomplywithhealthandsafety
regulations.Thecompanyexpectstogenerateapproximately$20millioninnew
equityinthecurrentyear.
Thecostofissuingnewequityhadbeenestimatedat8percentoffundsraised,
whilethecostofdebtisonly3percent.Companypolicyistoincludeallissuance
costsinthecostofcapital.

Decision Problems
Cummins,TeamBadgerleader,hasbeenaskedbyJaneMeadows,vicepresidentof
operations,tosupplyanestimateofthecostsofcapitalsuitableforanalyzingthese
twoexpansionprojects.Meadowsrequestedadetailedanalysisofhowthesefigures
werecalculatedandtheirlimitations.
MeadowsalsoaskedthatTeamBadgercompleteadetailedevaluationofthetwo
expansionoptions,calculatingcashflowsonaquarterlybasis.TeamBadgeris
expectedtomakearecommendationonwhichproject(s)toselect,andprovide
quantitativeandnonquantitativerationalesfortheirdecision.TheNPVapproach
shouldbetheprimarymethodused,aspercompanypolicy,buttheinternalrateof
return(IRR)shouldalsobecalculatedforeachproject.
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BUSN 6021: Corporate Finance

Exhibit 1

Calculation of Beta

Months

Stock
Index

PC Share
Price

Months

Stock
Index

PC Share
Price

4,834.78

41.34

31

6,289.78

61.67

5,100.56

44.49

32

6,305.53

62.98

4,789.45

38.23

33

6,310.76

63.33

4,900.45

44.67

34

6,450.33

65.44

4,901.34

47.83

35

6,477.88

66.56

5,265.95

49.78

36

6,485.94

68.34

5,560.34

48.94

37

6,432.94

65.78

5,660.87

53.23

38

6,600.00

67.57

5,500.23

48.64

39

6,734.55

68.34

10

5,798.34

60.34

40

7,321.34

74.99

11

5,900.65

63.57

41

7,454.34

76.54

12

5,927.03

57.34

42

7,645.48

79.67

13

5,803.34

55.30

43

7,903.33

73.44

14

6,034.33

58.56

44

8,134.33

78.34

15

6,100.93

60.20

45

8,234.33

81.23

16

6,378.45

64.55

46

8,305.33

83.33

17

6,456.33

65.44

47

8,300.87

83.45

18

6,409.37

64.32

48

8,413.75

85.66

19

6,543.55

67.68

49

8,500.33

86.55

20

6,698.33

70.23

50

8,700.34

91.00

21

6,703.87

70.78

51

8,654.00

89.03

22

6,684.34

69.23

52

8,778.30

91.33

23

6,834.95

72.75

53

8,503.00

89.33

24

6,699.44

67.45

54

8,876.33

93.44

25

6,584.50

64.35

55

8,903.33

94.34

26

6,593.22

65.78

56

9,034.44

95.87

27

6,534.56

63.45

57

8,953.33

94.34

28

6,667.98

66.34

58

8,957.32

95.43

29

6,490.88

62.65

59

9,003.78

95.34

30

6,389.22

63.67

60

8,933.68

94.33

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Case Study 3: Cost of Capital and Capital Budgeting

Exhibit 2
Stock and Bond Indexes
19732000
Year

Stock
Index

Bond
Index

1973

1,208

1,040

1974

886

1,030

1975

974

1,100

1976

1,012

1,174

1977

1,060

1,199

1978

1,310

1,245

1979

1,813

1,320

1980

2,269

1,390

1981

1,954

1,420

1982

1,985

1,480

1983

2,552

1,548

1984

2,400

1,603

1985

2,900

1,700

1986

3,066

1,732

1987

3,160

1,808

1988

3,390

1,900

1989

3,969

2,010

1990

3,257

2,020

1991

2,512

2,038

1992

2,350

2,098

1993

3,201

2,294

1994

4,213

2,384

1995

4,714

2,444

1996

5,927

2,600

1997

6,999

2,793

1998

6,486

2,700

1999

8,414

2,905

2000

8,933

3,145

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