Pleasure Craft Inc Case Study Solution
Initial Investment/ (1-Weighted Average Floatation Costs)
The weighted average floatation cost for the entire company has been calculated on the basis of the target capital structure of 30% debt and 70% equity of the company. The costs of issuing new equity and debt are 8% and 3% respectively, which provides us a weighted average of the flotation costs of 6.5%. The calculations could be seen in the excel spreadsheet. Finally, all the other calculations for the net cash flows of the project, including the terminal values in year 9 could be also seen in the excel spreadsheet. With the help of the net cash flows and 13.75% cost of capital; the net present value and IRR for the front-end loader project have been calculated, which are $-14.56 million and 0.34% respectively. (Suh, 1971)
Outboard Motor Project
This is the second investment option for the PC Company. This project would allow the company to remain within the leisure craft market and also utilize its existing selling network.
The annual cash flows have been computed for the 20-years life of this project, with gross investments in year 0 and terminal value realization in the last year. There would be no cash flows associated with the sales team development, as the sales team already exists.However, sales commission would still be paid to the members of the sales team. The calculations for the net cash flows for this project could be seen in the excel spread sheet.
With the usage of the calculated annual net cash flows and the cost of capital of 13.75%, the net present value for the Outboard Motor project is calculated to be $16.6 million, with an IRR of 22%. These values are quite higher as compared to the values for Front end loader project with negative NPV.
Sensitivity Analysis
From the above analysis, the recommended option for the company is the outboard motor project with NPV of 16.6 million and an IRR of 22%. However, a sensitivity analysis is required through the usage various WACC levels in order to follow a conservative approach in taking the investment decision, as the investment requires massive amount of funds. The sensitivity analysis for the project is provided in the excel sheet. (A Saltelli, S Tarantola, F Campolongo, 2004)
It could be seen in the attached excel sheet that with an increase of 5%; the NPV is still positive.However the NPV becomes -1.5 with an increase of 10% in WACC. Still the project can be considered as an optimal project on the basis of sensitivity analysis.
Evaluation of Financing options
As the project needs a huge amount of investment, the firm must consider various financing options to raise funds for the purpose of implementing an outboard motor project. In this regard, the company could consider various financing options that are elaborated below:(L Mura, J Buleca, 2012)
Retained Earnings
One of the major sources of funding the project is the utilization of internal financial resources. Although, the firm has a large amount of retained earnings, and it has been a frequently used source of funds for the firm, but as the project needs massive amount of funds and the utilization of internal resources for financing; the project could lead the firm to face liquidity problems.
Equity
Equity financing is another option that could be used to finance the outboard motor project. Equity financing helps the company to raise funds without damaging its credit ratings. It allows the firm to pay a variable cost in form of dividend. However, with the volatile earnings; the equity investors demand higher rate of returns than debt holders, which indirectly increases the cost of the capital.
Debt financing
Another option that could be used to finance the project is the acquisition of debt in form of long-term debt or bonds etc. Issuing the debt would enable the company to raise the funds at the minimal cost of capital and provides an interest rate tax shield. However, the largeamount of debt in the capital structure raises the investors’ concerns over the liquidity position and the future of the business.
Recommendations
On the basis of above qualitative and quantitative analysis of both the investment options and the evaluation of each financing option separately; the firm is recommended to pursue the manufacturing of outboard motor and financing the project at an optimal capital structure, where the WACC should be minimal. Outboard motor will enable the company to achieve potential growth with low chances of failure, as the company has an incredible experience in the market. Along with it, the manufacture of outboard motor project will provide huge amount of income to firm as it has a positive NPV, with an IRR of 22%…………
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