Ortho Decision Tools

Assignment #8 – Capital Decision Tools - Alexis Lake Background: Ortho Mfg. produces orthopedic implants used by physicians. The company’s publicly traded stock is currently selling for $50 per share. The company pays an annual dividend of $5 per share and senior management expects that to continue to grow by 5% per year.

The company has historically been profitable, but did see a decline in sales in the most recent recession. The corporate tax rate is currently 25%.

To finance their investment in assets, they used their triple BBB bond rating to issue a total of 250 IDA backed revenue bonds in 2004. The par value of each bond is $100,000 for a total capital infusion $30,000,000. Today, the bonds have 20 years remaining, and the balance owed is now only $25,000,000. The fixed coupon rate on the outstanding bonds is 7%. The bonds are currently selling in the secondary market for about $104,000.

Ortho Mfg. generated a 6% profit margin last year and they are on track to do that again this year. They have Total Assets of $50,000,000. These assets are financed 60% with Debt and 40 % with Equity.

Assets: Current assets All Other assets Total Assets Liabilities: Current liabilities Bonds Shareholders equity Common Stock Retained earnings Total Liab. & SH Equity

$7m $43 m $50 m $5m $25 m $18 m $2m $50 m

The company has been presented with 3 separate proposals for projects to consider in the coming year. They are expected to be highly reluctant to approve any project where the computed Internal Rate of Return is less than the average cost of capital computed by the finance director to be 9%.

Assignment Staff has been asked to submit their ideas for improving financial performance. Using the evaluation tools you have learned, calculate the a) annual cash flow b) payback period, c) NPV, and d) IRR for each project and indicate if you would recommend or reject the project.

Project #1 John Secor is a junior engineer assigned to Manufacturing and Operations. He is considered a rising star and one to watch. He has proposed a plan to enlarge and expand the plant’s production capacity. He believes the expansion could allow for the generation of an estimated $650,000 in additional revenue each year for the next 10 years. The cost of the expansion and required new equipment is projected to be $3,000,000. The new operating expenses would be $40,000 per years and in addition, there would be $30,000 of new depreciation each year. Working capital is deemed not to be a factor.

Annual Cash Flow New Revenue New Expenses New Depreciation New EBT: Taxes (25%): Net Income: New Depreciation: Cash Flow:

$650,000 ($40,000) ($30,000) $580,000 ($145,000) $435,500 $30,000 $465,000

Payback Period Required initial investment / annual net cash flow $3,000,000 / $435,500 = 6.88 = 7 years Net Present Value Cash inflow - Cash outflow (7.722 x $435,500) - 3,000,000 = $362,931 Positive NPV = Recommend project Internal Rate of Return Net present value factor = required initial investment / annual net cash inflow $3,000,000 / $435,500 = 6.88 IRR is 1% less than required 9% so reject

Project #2 Brian Allan is the company’s chief engineer for facilities and a big proponent of the green movement. He has proposed that the company should replace its main production equipment with new energy star, high efficiency digital equipment. His research leads him to believe the new equipment would cost $1,000,000 to acquire and install. The estimated useful life is 5 years. The new equipment would NOT generate any new revenue, but it is estimated to save $275,000 a year in the cost of production (raw materials, scrap and electricity). However, there would be new annual depreciation of $200,000 per year. There would be no salvage value or working capital implications.

Annual Cash Flow New Revenue Savings New Expenses New Depreciation New EBT Taxes (25%): Net Income: New Depreciation: Cash Flow:

$0.00 $275,000 ($1,000,000) ($200,000) ($925,000) ($231,250) ($693,750) $200,000 ($493,750)

Payback Period Required initial investment / annual net cash flow $1,000,000 / ($693,750) = -1.14 years Net Present Value Cash inflow - Cash outflow (4.329 x ($693,750) - $1,000,000 = ($4,003,243.75) NPV is negative = reject project Internal Rate of Return Net present value factor = required initial investment / annual net cash inflow $1,000,000 / ($693,750) = -1.14 Reject Project #3 Sharon Wood is the Vice President for Marketing. She proposes to expand the organization’s influence and market share by extending operations in the Southwest.

Specifically, she proposes the company open a new manufacturing facility in the Phoenix area. She has researched sites and has suggested one which could be leased and made ready for production in relatively short order. Her plan calls for the up front expenditure of $1,800,000 for equipment, installation and working capital needs. New revenue is projected to be $1,000,000 per year for the next 5 years with no salvage value. A determination could be made at that time to retool or close down the operation at the end of the 5 year lease. New costs consist of labor, benefits, raw materials, insurance, energy and depreciation. The sums of these items are projected to be $900,000 per year. Included in the new cost is depreciation expense which is forecast to be $400,000 per year.

Annual Cash Flow Ne Expenses New Revenue New Expenses New Depreciation Earnings Before Taxes:

(1,800,000) $1,000,000 ($500,000) ($400,000) ($1,700,000)

Taxes (25%): Net Income: Depreciation: Cash Flow:

($425,000) ($1,275,000) $400,000 ($875,000)

Payback Period Required initial investment / annual net cash flow $1,800,000 / (225,000) = -1.058 years Net Present Value Cash inflow - Cash outflow (4.329 x $(225,000) - $1,800,000 = ($9,159,300) NPV negative number - no do recommend Internal Rate of Return Net present value factor = required initial investment / annual net cash inflow $1,800,000 / ($1,700,000) = -1.058 Reject