7Project Evaluation Tortuga Fishing Equipment Company: Judson W. Russelln

7Project Evaluation: Tortuga Fishing Equipment Company: Judson W. Russell

Abstract

This case study on project evaluation is applicable for beginning courses in corporate finance or finance strategy. Two alternative investment options are available to evaluate.Challenges are presented with the inclusion of equity, bank debt,and bonds in the capital structure. Each investment option need to be evaluated carefully and decision should be made on the basis of thorough analysis of the data available using various capital structure and capital budgeting techniques.Keywords: Beta, Corporate Finance, Cost of Capital, Internal Rate of Return, Net Present Value JELCode: C10, G31, G32

Introduction

Brooks Hamilton recently accepted a job with Tortuga Fishing Equipment Company[1] (Tortuga) in the company Ac€?cs finance department. His first few assignments were fairly straightforward and Brooks relied on his background in both accounting and finance to get his career off to a great start. His manager, the company Ac€?cs Chief Financial Officer (CFO) was impressed with his work and decided to put Brooks on a new assignment. The firm was embarking on a new project which would define its future over the upcoming years. Given the importance of the project and high degree of visibility with the firm Ac€?cs senior management, Brooks was flattered to be asked to assist and eager to show that he was up to the task. The finance department was tasked with preparing an analysis to make a decision between two competing project plans which could very well decide the future of Tortuga in the competitive fishing equipment industry. The Chief Executive Officer(CEO) wants to have an answer from finance and expects a thorough analysis very quickly.The Company Tortuga is an Islamorada, Florida based company specializing in manufacturing high-end fishing rods and reels. Tortuga was founded by a retired university professor who fished all of his life and wanted to create the best equipment possible to handle a variety of fishing conditions and fish species. He partnered with an engineer who ran a machine shop to produce some prototype reels and supplied these to commercial fishing captains as test market research. The equipment produced by Tortuga was a significant improvement over the current line available and orders were strong. Through the years, the company made some modest improvements to their original prototype and had become an industry leader. Tortuga Ac€?cs products are used by tournament fishing teams around the world. Over the past decade, tournament fishing has grown to become a big business with corporate endorsements and prize money.This growth has made what was once a recreational vocation into a full-time profession for some anglers. The company recently launched an extensive research and development effort focused on a new fly rod and reel designed for one particular species of fish, the Atlantic Tarpon (Megalopsatlanticus). Tarpon are long-lived fishes that migrate in the warmer climes of the Caribbean Sea, Gulf of Mexico, and along the Atlantic Ocean coastlines. Although the fish can reach lengths of eight feet (~2.4 meters) and weights of 280 pounds (127 kilograms),they inhabit the shallow flats and exhibit acrobatic leaps when hooked. These traits make tarpon a popular game fish for anglers.Fishing gear needs to be sturdy to handle the power of these fish and Tortuga had developed products for this niche market which were allowing anglers to be successful in their angling pursuits.Recently, several sponsors had come together to launch competitive angling events called tournaments, where the best-anglers vie to catch, and then release, the most and largest tarpon. Winners may receive up to $50,000 in a single weekend tournament and the difference between winning and losing could be a few pounds. With so much money at stake, tournament teams purchase the best gear available and are always looking for any competitive advantage with their equipment. Tortuga is looking to capitalize on this trend by offering a new line called the Tortuga Tarpon Classic. This new line incorporates the latest material and design improvements and is predicted to be the Ac€A?gold standard Ac€?? for all serious tournaments anglers. Tortuga plans to offer the Tortuga Tarpon Classic to recreational anglers as well to capture the growing demand by affluent anglers who want the same high-quality gear as the professionals.Financial Information Tortuga began with a modest amount of capital that the founder had managed to save during his years in academia. As the firm grew,its financing needs expanded as well. Through the years Tortuga had developed and maintained a strong relationship with a large bank which provided short-term working capital funds in the form of a revolving line of credit. When a funding need arose, Tortuga would draw from this line of credit and then repay the short-term draw as cash flowed back to Tortuga. The $200 million revolving line of credit currently has $25 million drawn at an interest rate of 3-month Libor plus 350 basis points[2]. The remaining $175 million credit line can be assumed to have no fees associated with it[3]. Brooks looks up the most recent 3 month U.S. dollar Libor rate and sees that it is 1.50%.Long-term financing was also in place in two forms. After several years of revenue and earnings growth, Tortuga issued five million shares of common stock at an issue price of $10 per share.The firm used this $50 million in funding to increase production lines and build a global presence by opening an additional manufacturing facility in Panama. Brooks finds the current price per share for Tortuga to be $16. Two years ago, Tortuga issued a 10-year bond for $50 million face value. Each $1,000 par bond carries a coupon of 8.5%. The bond pays interest semi-annually and is currently trading in the market at 102.50 as a percent of par.The company has a 34% corporate tax rate.The firm calculates its required return on equity with the Capital Asset Pricing Model (CAPM) using a 4.0% historical Treasury rate for the risk-free rate and 6.0% as the historical market risk premium[4]. CAPM = Risk-free rate + beta(Market Risk Premium) (1)The annual stock returns versus the market are shown in Figure 1 below for the past 10 years. Beta is calculated by regressing Tortuga stock returns on the Standard & Poor Ac€?cs (S&P) 500 returns. There are a variety of methods for calculating beta.Brooks could find beta by regressing five years of weekly Tortuga returns of the S&P 500. He could use five years of monthly returns or two years of weekly returns. Each of these is a valid sample period. One well-known data source provides an Ac€A?adjustedAc€??beta which is determined by first calculating a Ac€A?raw Ac€?? beta by regressing two years of weekly security returns on the market. This is then adjusted by taking 2/3 of the raw beta plus 1/3 of one.This adjusts the beta to be closer to one, since beta is notstationary and should naturally move towards one through time as afirm expands. Brooks only has 10 years of annual data available atthe time and decides to conduct the analysis with this informationto get a quick response. He will check his result with more datapoints before submitting his final report to theCFO. Figure 1 Returns on Tortuga Stock versus the Standard & Poor500YearTortuga returnS&P 500 return1127222163-2-3414959861921716178-10-5979101214After Brooks calculates beta he employs formula (1) above alongwith the risk-free rate and market risk premium to determine thecost of equity. The firmAc€?cs weighted average cost of capital is afunction of its equity market capitalization, cost of equity,short- and long-term debt amounts and costs, and the tax rate.Using formula (2) below, Brooks can find the firmAc€?cs weightedaverage cost of capital (WACC).WACC = wdkd(1-T) +weke where:WACC= weighted average cost of capitalwd = weight of debt to total capital (note: this includes short-and long-term)kd = cost of debt using yield to maturity and current values forshort-termT = corporate tax ratewe = weight of market capitalization to total capitalke = cost of equity determined with CAPMTortuga Tarpon ClassicThe company has two separate research teams working on theproject and they develop two distinctly different fishingcombinations. The two rod and reel combinations are test marketedwith guides and past tournament champions and demand forecasts aredetermined. Most fishing gear has a relatively short life due tocontinual product innovation. Manufacturing of the two combinationsis estimated to require an upfront cost of $5 million to retool themachine shop. The process for manufacturing the two combinationsdiffer and ongoing variable costs are not the same. The net cashflows for the entire ten year expected life of the product is shownin Table 2 as Project A and Project B (all figures are $thousandsof net cash flow). Project A focuses on hand tooled fishing equipment which resultsin a more labor intensive process, but also allows for personalizedfeatures for customers. The price charged for customization offsetthe slower hand tooling process to generate substantial net cashflows. Part of the upfront $5 million includes the costs oftraining more machinists in the art of hand tooling, which issimilar to watch making but with a few less moving parts. Project Ais anticipated to generate lower cash flows in the early years dueto the length of time required to get machinists who are adept athand tooling to customer specifications. In fact, during the firstyear there will be continued expenses to attain these skills whichcauses year one net cash flows to be negative. Over time the cashflows increase as more machinists gain proficiency. The project isexpected to experience lower cash flows towards the end of its lifedue to market saturation. Due to the quality of the reels, they arebuilt to last and seldom fail or wear out. Technologicalobsolescence is certain although Tortuga will be investing cashflows into research and development to launch the next generationat the conclusion of the Tortuga Tarpon Classic life cycle.Project B employs a mechanized approach to large scaleproduction of standardized equipment. Although the approach doesnot allow for personalization, it does allow Tortuga to build itsinventory quickly and capture positive net cash flows immediately.The upfront expense is almost completely devoted to toolingequipment procurement and the number of units produced will be muchhigher and at lower price points than the approach of Project A. Atthe end of both projects life it is assumed that there will be zerosalvage value as the pace of innovation will require a completere-tooling for the next generation and the useful life of theequipment will have been fully realized.Brooks realizes that he will need to calculate the firmAc€?cs costof capital discount rate and apply this to the cash flowprojections of both projects. He recalls all of the assignments hecompleted at university and is thankful to have been sowell-prepared for this task. He gets a cup of coffee, sits down athis desk, and gets to work.Figure 2 Project Net Cash Flows for Tortuga Fishing Equipment($thousands)yearproject Aproject b1-900950220095039009504180095052500950625009507180095081200950980095010200950Since Brooks is new to his role, you have been asked to reviewhis work and assess the financial viability of the projects. Giventhe importance of this decision you are helping to make sure thefirm makes the right choice. Specific Questions1.Using the Capital Asset PricingModel, what is the required rate of return on equity, ke(cost of equity) for Tortuga?2.Analyzing the companyAc€?cs bond,what is the yield to maturity on the bond issue, kd(cost of debt)?3.Using the market weight ofequity, the original issue amount of debt, and the outstandingportion of the revolving line of credit, what are the weights ofequity and debt in the capital structure (we &wd)?4.Using the information provided,what is the firmAc€?cs weighted average cost of capital (WACC,ka)?5.What are the net present value(NPV), internal rate of return (IRR), and Payback Periods forProjects A & B?6.What decision rules will you useto help Tortuga reach a decision?7.What are the strengths andweaknesses of each of the evaluation tools?8.What do you suggest toTortuga?AuthorJudson W. Russell, Ph.D, CFAClinical Professor of Finance, Belk College of Business,University of North Carolina Charlotte,|!