FBL5030 Fundamentals of Value Creation
The Hamilton Fishing Company (HFC) purchased a trawler 6 years ago for $820,000 (Trawler A). At the time it was purchased, the trawler had a useful life of 10 years. If HFC were to retain this boat, the company anticipates it will have to install an ultrasonic detection equipment at a cost of $60,000. However, the Commercial Trawler Company (CTC) recently launched a faster, computer-assisted trawler that HFC is considering as a replacement (Trawler B). This trawler will cost $1,250,000 but will need custom refitting to suit the purchaser’s specifications at an additional cost of $150,000. It has an expected useful life of 12 years. Both trawlers and refurbishments can be depreciated on a straight-line basis. If purchased, Trawler B is likely to increase operating costs to $20 per tonne of fish, which currently sells for $40 per tonne. However, future catches are likely to increase significantly by 3000 tonnes in the first year, then at a rate of 1500 tonnes per annum, and stabilising at annual increase of 700 tonnes per annum after the sixth year. Owing to intensive usage, it is expected that towards the end of the fifth year Trawler B will require a minor engine overhaul at a cost of $140,000, pre-agreed upon with CTC. Part of the purchase agreement also involves a maintenance contract with CTC covering the nets and trawling apparatus, which will cost HFC $75,000 payable at the start of each year. Presently, Trawler A yields an annual catch of 5000 tonnes of fish. Operating costs are $15 per tonne of fish. HFC has a maintenance contract with CTC to maintain the boat’s functionality, at a cost of $38,000 per annum payable at the start of the year. If HFC decides to replace Trawler A with Trawler B immediately, the company expects to auction off the old trawler for $165,000. If the old trawler is kept for another four years, the company does not expect any scrap value for the boat. Trawler B is expected to fetch $250,000 in the second-hand market at the end of its useful life. HFC’s managers believe that relative to today’s prices, the average inflation rate is expected to be 8% per annum. However, the impact of inflation will vary on the price of fish and operating costs because of negotiated contracts with suppliers and labour unions. The market price of fish expected to rise at a rate of 6% per annum, while operating costs are expected to rise at a rate of 3% p.a. Maintenance costs payable to CTC will not be affected, as these have been under contract at the time of purchasing the trawler. The corporate tax rate is 30%. HFC is a profitable company and so it expects to fund any new capital investment with its retained earnings, and raise new debt and equity funding to maintain its current capital structure proportions. The firm’s current cost of capital is 14% p.a., comprised of a 10% p.a. cost of debt and 18% p.a. cost of equity. If any new funding is needed, the company will finance the capital requirements with borrowing and equity contributions to keep the current 50/50 proportions in its capital structure. Any new borrowing or equity raising is expected to be at the same costs of capital as current arrangements. Your task is to prepare an investment recommendation report to the Board of Directors at HFC. Your investment recommendation must indicate whether: (a) the company should keep Trawler A for another four years before replacing with Trawler B, or (b) replace Trawler A with Trawler B immediately. The content of your discussion should address the issues raised in Questions 1 to 7. You should also discuss the assumptions you have made, and justify your choice based on sound investment selection criterions. The Board would also like you to address key areas of concern impacting the feasibility of the project. You must attach all relevant workings and calculations at the back of your report as an Appendix to support your discussions. Page 4 of 6 Address the following within your Investment Recommendation. 1. The market price and operating costs for both trawlers are applicable today. Set up schedules of market price per tonne, operating cost per tonne, and annual catch size to assist in estimating annual cash flows for both options. 2. Prepare the incremental cash flow tables for (a) the choice to Keep Trawler A for another four years before replacing with Trawler B, and (b) the choice to replace Trawler A with Trawler B immediately. Assume these are the base case scenarios for each option. 3. Determine the basic NPV today and IRR for each choice. Discuss which choice is recommended on the basis of each measure. 4. How would your recommendation change when the difference in project lifespans are taken into consideration? 5. For both investment choices, determine the minimum market price of fish, and maximum operating cost per tonne of fish at the end of the first year in order to breakeven. Discuss your results, addressing the implications to your recommendation. 6. The Board would like you to consider the implications of the following risk factors when making the investment recommendation: - The annual catch is subject to various environmental factors. Though currently it is estimated at 5000 tonnes (based on Trawler A), this can vary by  25% by the end of the first year. - The market price of fish is currently $40 per tonne. Demand and supply can vary over time due to various factors. The price of fish can vary by  20% by the end of the first year. - Operating cost per tonne of fish can vary by  30%, largely due to energy/ fuel costs expected to undergo market volatility over the coming year. 7. Without any calculations, the Board would also like you to provide a preliminary discussion on whether Trawler B should be leased or purchased outright. Your discussion should indicate whether an operating or finance lease may (or may not) be beneficial, and if so, how. Consider the implications of the choice to lease on the firm’s capital structure, and how it changes the framework of your investment analysis
