Research Paper on Financial Risk
Management had chosen not to deal with other varieties because it wanted to concentrate on the higher-priced end of the seafood market. However, increased competition from low-cost foreign producers has hurt profits, and over-harvesting and pollution have decreased the fish and shellfish populations, resulting in significantly lower yields. Furthermore, consumers are becoming more price conscious and are avoiding more expensive seafood in favor of less expensive freshwater fish, especially catfish and freshwater trout, and chicken.
Individuals who had at one time preferred to eat red meat are now turning to fish as a more healthy diet alternative, but the freshwater producers are capturing most of that rising market. This combination of factors has prompted Atlantic to reconsider its basic strategy, and management is now thinking of making a major move into the freshwater fish market by raising and harvesting rainbow trout. The company was founded in 1948 in Maine by a consortium of commercial fishermen whose plan was to provide Americans throughout the country with fresh North Atlantic specialty seafood.
Atlantics sales in 1 995 were $39 million, and its net income was $900,000. The company’s seafood is regarded as being of the highest quality, and the firm has the reputation of being a leader in its chosen field. Still, for the reasons cited above, the profit trend has been downward in recent years, and unless there are fundamental changes, losses will eventually occur. All prior proposals to enter the trout market were rejected because Atlantics operating and marketing advantages were in specialty seafood (saltwater products).
Furthermore, management previously had not regarded the trout arrest as having enough profit potential to make the investment worthwhile. Recently, though, slow economic growth throughout the country has led to massive layoffs which have forced consumers to be more price conscious with their fish selections, and consumer demand for freshwater fish throughout the united States has increased. Consequently, entering the freshwater fish market may provide an attractive investment opportunity. Marketing the product under Atlantes name and thus capitalizing on its reputation for quality and Copyright 0 1994. The Dryden Press. All rights reserved.
Case: BIB Capital Budgeting with Staged Entry rashness will increase the probability that the project will be financially successful. Finally, a few of Atlantics executives believe that it simply must make a strategic change if it is to reverse the downtrend in profits. Atlantics managers are examining two alternative proposals for entering the trout market. Plan L (for large) calls for the immediate development of a large facility that would house the entire freshwater fish processing division-?trout holding ponds, a hatchery, a major processing plant, research and development (R), marketing, and general management.
Plan S (for small) alls for the initial construction of a smaller, unsophisticated, no-frills processing plant with limited capacity, and fewer holding ponds, followed in three years (if the project is successful) by an expansion to a facility similar to the one called for under Plan L. If the large plant is built immediately and demand is high, the per unit cost of trout will be lower than if the small plant strategy is adopted. Those low costs would enable the company to sell trout at a lower price than competitive products, especially other seafood and chicken.
To date, Atlantic has spent $600,000 on R, including marketing tidies, on the trout project. Of this amount, $240,000 has been expensed for tax purposes, while the remaining $360,000 has been capitalized and will be amortized over the first 3 years of the operating life of the new facility. According to an IRS ruling specifically requested by Atlantic, the $360,000 of capitalized R expenditures can be expensed immediately if the trout project is not undertaken. If Atlantic decides to go forward with the project, it will require a 50-acre site by December 31 , 1996 (t = 0). It will utilize the same site for either Plan L or S. ) The firm has decided to locate the facility just north Of Portland, Maine, in a pristine environment which faces no danger from pollution yet has good access to the firm’s present headquarters and other processing facilities. Atlantic currently owns a suitable tract of land which could be used for the project. The tract was acquired for $300,000 several years ago, but it could be sold now for $900,000, after real estate brokerage fees and taxes. Other suitable sites could also be purchased for $900,000.
The site currently owned was purchased by the Salmon Division, which plans an expansion in 2002. If the site is used for the trout project, Atlantic would have o make other arrangements for the Salmon Division. Atlantic can obtain an option on a similar site in the same area for a cost of $60,000, with the option to be paid on December 31, 1996. The option would give Atlantic the right to purchase the site on December 31, 2000 (t 4) for $1 It is estimated that this and other similar sites appreciate at the rate of 6 percent annually.
Therefore, a site for the Salmon Division could be acquired at a later date, should the currently owned tract be used for the trout project. If the land is used by the trout division, it could probably be sold at any point in the rejects life for its appreciated value, should the trout project be abandoned. State, county, and city approvals have already been obtained. Construction would take place during 1997 at a cost of $3 million for Plan L and SSL . 2 million for Plan S. For planning purposes, management assumes that these expenditures would occur on December 31, 1997.
The Plan L plant would have a capacity of 22,000 tons; the plan S plant would have a capacity of 9,000 tons. The buildings would fall into the MACRO 31. 5-year class, and Atlantic could begin to depreciate them during 1998, the year either plant would go onto service. The second stage of Plan S would require additional construction at a cost of $2. 4 million, assumed to be paid on December 31, 2000, and the expanded plant would commence operations on 1/112001 and provide cash flows beginning on 12/3112001.
The second-stage plant would increase capacity to 21 ,OHO tons, and it too would be depreciated over a 31. 5-year life, beginning in year 2001. Although the depreciable life of each plant is 31. 5 years, Atlantic assumes that it would actually operate the facility for only 7 years, regardless of which plant is selected. There is a good chance that the company would sell out to a larger corporation by then. In addition, management prefers not to project operating lives of more than 7 years, but to calculate a terminal value as of the end of the 7th year.
Production under either plan would begin on January 1, 1998. Operating cash flows (end of year) are assumed to begin on December 31, 1998, and to run through December 31, 2004, or 7 years in total. Atlantic estimates that the land would have a market value of just under $1. 5 million at the end of 2004, based on the assumed 6 percent appreciation rate. At that time, the buildings could probably be sold for about half their book value. The required processing equipment would be obtained and installed during 1997 at a cost of for the large plant and $3,600,000 for the Plan S plant.
Payment would be made on December 31, 1 997, and the equipment falls into the MACRO 7-year class. The second stage of Plan S would require an additional for equipment, paid on December 31, 2000, and Stage 2 operations would begin on January 1, 2001. As with the building, depreciation would begin when operations commence, in 1998 and 2001 for Stages 1 and 2, respectively. However, if the project is terminated, wear and tear, along with technological obsolescence, would cause the equipment to be worth very little to another party, so the best estimate of the salvage value is about half of its book value.
Table 1 contains the depreciation rates as provided by the firm’s accountants. The initial investment in net working capital would equal 25 percent Of the estimated first-year sales for the large plant and 30 percent for the small plant. The company assumes that this investment would be made on December 31 , 1997. Additions to net working capital in each bequest year would be 25 or 30 percent, for the large and small plants, respectively, of the increase in dollar sales expected during the following year.
For example, additional net working capital required to support the growth in sales from 1999 to 2000 would be 25 percent of the increase in sales if Plan L were adopted and 30 percent of the sales increase under Plan S, and the working capital investment would be paid for on December 31, 1999. The production manager estimates that variable costs would be 60 percent of sales for the large plant and 65 percent for the small plant, but these regenerates could also vary. If the small plant is expanded, the estimated variable cost ratio would remain at 65 percent.
However, the controller is concerned that all of the forecasted variable cost percentages are too optimistic, especially if demand turns out to be weaker than expected. Fixed costs, excluding depreciation, are estimated to be $3. 6 million in 1 998 for the large plant and SSL . 8 million for the small plant. These costs include such things as managerial salaries and property taxes, but not depreciation, and they are expected to increase after 1998 at the same rate as general inflation, expected to average 4 percent. Expanding the small plant would add an additional $1. 8 million to the then-existing fixed costs beginning in 2001.
Atlantics marketing department assumes that trout will sell for $1 ,320 per ton in 1998, and it has projected that demand could range from a high of 10,000 tons to a low of 5,000 tons in 1998. Of course, this could vary depending on consumer tastes and competition. Further, unit sales are expected to increase at an annual rate of 10 percent if the initial demand is high, but to grow by only 2 percent if the initial demand is low. The sales price ill vary depending on conditions in the trout market. Atlantic hopes to increase prices at the same rate as general inflation, which is projected at 4 percent.
Based on studies done to date, the marketing department estimates that there is a 75 percent probability that initial demand in 1998 will be high (10,000) and a 25 percent chance of low initial demand (5,000). If demand is high initially, then the growth rate would probably be toward the upper end of the range (1 0 percent), while a low initial demand would probably signal low growth (2 percent). When pushed, the marketing UP estimated that there s an 80 percent chance that growth will be high if the initial demand is high but only a 20 percent chance of high growth following low initial demand.
If management decides to close the operation, the plant and equipment could probably be sold for about half their book values at the time of abandonment, while the land could probably be sold at Its appreciated value. Due to existing labor contracts, abandonment would be almost impossible prior to 2000, even if sales were terribly low and costs terribly high. Thereafter, abandonment would involve no extraordinary costs. Atlantics uncial vice president has read articles in finance journals that discuss the fact that NP analysis doesn’t normally consider opportunities created by the acceptance of a project, I. . , strategic options. Some of the articles suggested that the existence of an opportunity to abandon a project in effect means that the project also contains an embedded put option, which means that the project has more true value than would be indicated by a “straight” NP analysis. She believes that the articles also state that this value can be estimated through the use of decision trees. Since the analysis will be conducted over only a 7-year operating period, estimating the terminal value is a critical issue.
If things were going well, then the facility would undoubtedly continue to be operated or else sold as a going concern, and it would probably be at some multiple of the net income generated during 2004. For example, it might be sold for 8 times the 2004 net income. If the facility were unprofitable or marginal, and the salvage value exceeded the going concern value, then the plant would be closed and the assets liquidated at their salvage values. Management thinks that the best estimate of the terminal value is the higher of the salvage value or a going concern value found as 6 to 10 times net income.
Atlantics federal-plus-state tax rate is 40 percent. Its weighted average cost of capital is 9 percent, but Atlantic adjusts the WAC up or down by 3 percentage points for projects with substantially more or less risk than average. Risk is estimated subjectively, although sensitivity analysis and scenario analysis are considered in the judgmental risk assessment. Your consulting firm has been asked to analyze the trout project, and you must perform the analysis and cake a recommendation for Atlantics executive committee.
In developing your recommendation, don’t forget to address all the issues posed by the financial vice president. She specifically wants you to consider how the firm should handle the land acquisition for the Atlantic Salmon processing Division should the currently owned site be used for the trout project. In addition, she wants you to address the option value created by the abandonment opportunity, and to quantify it as best you can. Also, if other strategic option values might be involved, discuss them and indicate how they might be evaluated.
An intern who worked for Atlantic prepared the decision trees for both the large and small plants as shown in Figures 1 and 2. Note that the intern did not completely finish the decision trees, so you must do that. In addition, the intern started, in Tables 2 and 3, to provide cash flow statements for the large and small plants assuming high initial demand, a high growth rate, and no abandonment prior to 2004. The trout project would represent a major shift in corporate strategy for Atlantic, so you will be questioned sharply by all members of the executive committee on both the assumptions ND the analytical methods that you use.
Everyone will want to know how the results would change if any of the basic assumptions were changed, so you should prepare some sensitivity analyses which you can use to respond to such questions. To help structure your analysis and report, answer the following questions. QUESTIONS 1 . Consider the land acquisition. A. What cost, if any, should be attributed to the trout project? B. Assuming that the currently owned site is used for this project, how should the Salmon Division obtain a site? What discount rate should be used in analyzing the option alternative? Now think about the other cash flows. A. If the project is undertaken, what would the R cash flows be in 1 998 through 2000? Should any R cash flow for 1996 be included in the analysis? Explain. B. Describe how salvage values are taxed. Use the buildings salvage value to illustrate your answer. C. Complete the large plant, high demand, high growth cash flow statement by filling in the blanks in Table 2. 3. Assume that the large plant project is judged to be of average risk. What are its stand-alone NP, AIR, MIR, and payback if initial demand and growth are both high?
What are the values for these same variables if the small plant is built and demand and growth are again high? 4. A. Examine the decision tree for the large plant, and discuss what it is designed to do and how it works. Focus first on the left section, where probabilities are given; then describe the cash flows; then explain the Naps; then explain what the joint probabilities are, what they mean, and how they were calculated; then explain what the products are; and finally explain the expected NP, standard deviation, and coefficient of variation terms. B.
Explain the abandonment lines and discuss why the product terms are based on abandonment. C. If a contract with the city of Portland would rule out the possibility of abandonment prior to 2004, what would this do to the project’s expected profitability and risk? 5. A. Now consider the small plant decision tree. Why are there more branches on that tree than on the large plant tree? B. Why does each branch not have a joint probability and product? Why are those terms shown for the branches where they appear? 6. Based on the data in the decision trees, which plant has the higher expected NP?
Which appears to be riskier? Do you think the same cost of capital should be used to evaluate both plants? 7. If most of Atlantics projects have a coefficient of variation in the range of 0. 5 to 0. 7, how might this information be used in the analysis, and what effect might it have? 8. Suppose you were told that your boss had reassessed the probabilities. How would the situation change if these new probabilities were assumed? High initial demand 0. 9, High growth 0. 9. Or High initial demand 0. 6, High growth = 0. 5. Which set of revised probabilities would favor the large plant?
Which would improve the relative status of the small plant? 9. Sensitivity analysis is often used to help assess the rockiness of projects such as this. How might sensitivity analysis be applied here? If you are using the computer model, change the inputs and see how sensitive the output variables are to input changes. 10. Scenario analysis is also used in capital budgeting. Explain how it might be used here. What variables would you want to change, and where would you get ranges for those variables and probabilities of different values? 1 1 .
