Capital Budgeting Case                                                      Spring, 2014

FIN 3210                                                                                                       

Due: 4/25/14

Titan Manufacturing (TTN) is considering expanding into the Southeastern U.S., adding 40 centers to its fleet of 125. As the expansion is expected to significantly enhance both revenues and costs, senior management is concerned about the profitability of such a major expansion. As a result, you were recently hired to participate on a team under TTN’s CFO that is responsible for evaluating the cash flows and profitability associated with this specific project (beginning in the summer of 2014).

Initially, your team concludes that such a full-scale expansion would require an increase in capital expenditures of $22,900,000. In addition, to accommodate increased cash and inventory needs, net working capital requirements are expected to rise by $1,320,000 so the new centers will be operationally functional. The firm expects that 79% of the increase in net working capital will be returned at the project’s termination. The capital equipment is to be depreciated using a 7-year Modified Accelerated Cost Recovery System (MACRS) schedule. Not knowing what the future holds, your team also concludes that this expansion will exist for 5 years – thereby finishing in the summer of 2019.

Adjustments to the company’s operating cash flow’s are expected to begin in June of 2014 – when the centers are deemed fully operationally functional. Also, the capital equipment is expected to have a market value of $4,189,000 at the project’s termination.

Last, your team makes the following assumptions regarding marginal increases in sales and costs for FM:

• 445,000 more units will be sold in years 1-2, generating on average $18.50 per unit, while 485,000 units will be sold in year 3-5 at an average sales price of $14.50 per unit.
• Total operating costs (both fixed and variable) are anticipated to be 55% of sales in years 1 & 2 and 50% of sales in years 3-5.
• FM’s marginal tax rate is 34% (used in both deriving Operating Cash Flows as well as tax loss/gain in salvage value).

Last, you assume that TTN will raise all of the capital to finance this project using a blend of debt and equity and intends to use the same capital structure to raise the funds for this expansion. As a result, you base your cost of capital assumptions on the following:

• The firm currently has 280 bonds outstanding with the following terms:
• Remaining Maturity = 5 years, Coupon Rate = 4.28% (semiannual pay), Current Price = $990.
• The firm currently has 28,000 common shares outstanding with the following price and market terms:
• Stock price = $52; Beta = 1.28; Rf Rate = 1%; ERm = 6%
• The firm currently has 12,000 preferred shares outstanding with the following terms:
• Share price = $78; Dividend Rate = 2.75%

In order to evaluate this project, answer the following questions in deriving a cash flow analysis and recommendation.

1. What is the initial cash outlay (CF0)?

1. What are the operating cash flows in years 1 thru 5 – adjusted for taxes and depreciation?

1. What are the terminal-year cash flows added to the operating cash flow in year 5?

1. What is the Weighted Average Cost of Capital, assuming you use existing capital structure?

1. Given your results for CF0 thru C05 and the cost of capital, would you recommend that the company take-on this project? Compute and explain the significance of the NPV & IRR to support your answer.

1. Judging the existing weights in TTN’s capital structure, comment on how the firm might lower its NPV and enhance its NPV and firm value by adjusting these weights. What could be the good/bad consequences of such adjustments?