1/25/02 2/5/02 02:53 PM 4414\4414-00\105-case

105
Capital Budgeting with Staged Entry

Sea King Corporation

Directed

Sea King Corporation processes and markets saltwater fish, crabs, lobsters, shrimp, oysters, scallops, and clams. The company presently handles only seafood from the Atlantic Ocean and the Gulf of Mexico, but for three reasons management is considering a change in its corporate focus. First, over-harvesting and pollution have decreased the fish and shellfish populations, resulting in lower catches per boat trip, and that has hurt profits. Second, Sea King is facing increased competition from low-cost foreign producers. And third, the government occasionally bans shellfish harvesting along much of the Atlantic and Gulf coasts, after people have become sick from eating contaminated product. So, in early 2002 Sea Kings CEO scheduled an executive committee meeting to consider a major move into the salmon farming business, where salmon eggs are hatched and then the fish are raised to marketable size in saltwater holding ponds. The company was founded in 1964 by a group of Louisiana fishermen, and by 2001 sales were $130 million and net income was $3 million. The companys seafood is regarded as top quality, and Sea King has a reputation for delivering an excellent product at a competitive price. Still, for the reasons noted above, the profit trend has been downward in recent years, and unless things change, losses will eventually occur. Proposals to enter the salmon farming business have been raised in the past, but they were rejected because management did not regard salmon farming as having sufficient profit potential. Recently, though, a shortage of wild salmon has led to price increases, and some Sea King executives who were formerly skeptical about the salmon project are now convinced that the company is going to have to take some chances if it is going to reverse the profit slide. Sea King is considering two alternative proposals for the salmon project. Plan L (for large) calls for the immediate development of a large facility that would house the entire fresh fish processing divisiona hatchery, salmon holding ponds, a large-scale processing plant, research and development (R&D) labs, marketing, and general management. Plan S (for small) calls for the construction of a smaller, unsophisticated, no-frills processing plant with limited capacity and fewer holding ponds. If things go well, then under Plan S the plant would be expanded in 3 years to a facility similar to the one called for under Plan L. To date, Sea King has spent $2 million on R&D, including plant design and marketing studies, on the salmon project. Of that $2 million, $800,000 was expensed for tax purposes, while the remaining $1.2 million has been capitalized and will be amortized over the first 3 years of the operating life of the new facility. However, the $1.2 million of capitalized R&D can be expensed immediately for tax purposes if the salmon project is rejected.
Copyright 2002 by South-Western. All rights reserved.

If Sea King goes forward with the project, it will need a 50-acre site by December 31, 2002 (t = 0). It will utilize the same land for either Plan L or S. The facility would be located on Cape Cod, which has a cool year-round climate that is ideal for optimal salmon growth. The firm currently owns a suitable tract of land which cost $1 million several years ago but which could be sold now for $3 million, net of real estate brokerage fees and taxes. Similar sites could also be purchased for $3 million. The site currently owned was purchased for the Lobster Division, which plans an expansion in 2006. If the site were used for the salmon project, Sea King would have to make other arrangements for the Lobster Division. An option to purchase a similar site in the same area on December 31, 2006 (t = 4) for $3.8 million can be acquired at a cost of $200,000 to be paid on December 31, 2002. This and similar land in the area is expected to appreciate at a rate of 9 percent annually, and a site for the Lobster Division could be bought in 2006 if the currently owned tract is used for the salmon project. Also, the currently owned site could probably be sold at any time for its appreciated value should the project be abandoned. State, county, and city approvals have already been obtained. The building would be constructed during 2003 at a cost of $10 million for Plan L and $4 million for Plan S. For planning purposes, management assumes that payment for the building would occur on December 31, 2003. The Plan L plant would have a capacity of 22,000 tons, while the Plan S plant would have a capacity of 8,000 tons. The buildings would fall into the MACRS 31.5-year class, and Sea King would begin to depreciate them during 2003, the year either plant would go into service. The second stage of Plan S would require a major additional to the building at a cost of $12 million, which would be paid on December 31, 2006. Also, additional equipment would be needed. The additional equipment would cost an additional $12 million (the same as the original equipment), and it would be paid for on 12/31/06. The expanded plant would commence operations on 1/1/2007, and it would provide cash flows in 2007. The expansion would increase capacity to 20,000 tons. The new building would be depreciated over a 31.5-year life, beginning in Year 2007. The required processing equipment for the large plant would be acquired during 2003 at a cost of $20 million. Payment for the equipment would be made on December 31, 2003, and it falls into the MACRS 7-year class. As noted above, Plan S would require an additional $12,000,000 of equipment for its second stage, should the firm elect to expand. Stage 2 operations would begin on January 1, 2007. As with the building, depreciation on the equipment would begin when operations commence, in 2004 and 2007 for Stages 1 and 2, respectively. However, if the project is terminated, wear and tear, along with technological obsolescence, would lower the value of the buildings and equipment, and the best estimate of the salvage value is about half the book value. The initial investment in net working capital would equal 25 percent of the estimated firstyear sales for the large plant and 30 percent for the small plant. Payment for this net working capital would be made on December 31, 2003. Additions to net working capital in each subsequent year would be 25 percent of the increase in dollar sales expected during the following year for the large plant and 30 percent for the small plant. These costs would be incurred at the beginning of each new year. If the salmon farming operation is undertaken, and if it is successful, it would presumably go on indefinitely. However, for planning purposes, Sea King makes explicit forecasts for a maximum of seven years of operations. Then, it calculates a terminal value which is designed to capture all future cash flows. So, for planning purposes you are to assume that production would begin on January 1, 2002, and operating cash flows (end of year) would begin on December 31, 2004, and run through December 31, 2010, or 7 years in total. Management estimates that the land would
Copyright 2002 by South-Western. All rights reserved.

have a market value of just under $6 million at the end of 2010, based on the assumed 9 percent appreciation rate. At that time, the equipment could probably be sold for about half its book value. The land and building would be sold together at a price that was about equal to the appreciated value of the land plus one-half the book value of the building. The production manager thinks that variable costs for the large plant would be approximately 60 percent, though that percentage could be higher or lower. For the small plant, the expected variable cost is 65 percent, although again the actual number could be higher or lower. Fixed costs (excluding depreciation) for the large plant during the first year of operations (2004) are estimated at $12 million. The expected fixed cost for the small plant with no expansion is $6 million, but fixed costs would double if the expansion is made. These costs include managerial salaries and property taxes, but not depreciation, which are treated separately on the income statement. Moreover, fixed costs are expected to increase after 2004 at the same rate as general inflation, which is projected at 4 percent. The marketing vice president expects the demand for salmon in 2004 will be about 9,000 tons, but she thinks it could easily range from 6,000 to 11,000. Marketing also expects demand to increase at an annual rate of about 8 percent, but the range could be between 5 percent and 9 percent. Salmon is expected to sell for between $3,000 and $4,500 per ton, with a most likely value of $4,400, when the plant goes into operation in 2004. Moreover, marketing thinks salmon prices will increase at the same rate as general inflation, which is projected at 4 percent. Sea Kings CEO and CFO discussed the information given in the preceding paragraphs at length. The CEO argued that if good things occur during the first year of operations, that would signify good things in the futurehigh demand, low costs, etc. This is called inter-temporal correlation. He wondered, though, whether or not the input variables would be correlated with one another. For example, would high demand result in both high sales in tons and a high market price? Or, would high prices be associated with low demand? The CFO took a somewhat different position, arguing that the fish business is subject to random variations, so high first-year demand could be followed by low demand, low costs could be followed by high costs, and so forth. In the end, they decided to ask the consultants to consider (1) how the input variables would be correlated and (2) how correlations would affect the profitability and riskiness of the project. If the company takes on the project but later decides to close the operation, it is estimated that both the building and the equipment could be sold for about half their book values as of the date of the abandonment, and the land could be sold at its appreciated value. Cash from an abandonment sale would come in one year after the operation was closed. Due to labor contracts, abandonment would be impossible prior to the end of 2006, even if the initial results were terrible. After 2006, however, abandonment would be feasible, and it would involve no additional costs. Thus, if the operation were closed down at the end of 2006, the sale price would be 50% of the book value of the building and equipment, plus the land value, as of 12/31/06, but the cash from the sale would not come in until 12/31/07. The investment in working capital would be recovered during the last year of operations, e.g., during 2006 if the operation were abandoned at the end of 2006. The company might or might not be able to recover the full cost of the working capital. Since the analysis will focus on a 7-year operating period, estimating the terminal value is a critical issue. If the operation is highly profitable, then the facility would continue to be operated or else be sold as a going concern. In either case, it would probably be worth about 6 times the net income generated during 2010, with a range of 5 to 7 times. However, if the operation is unprofitable, then the plant would be closed and the assets liquidated at their salvage values. The
Copyright 2002 by South-Western. All rights reserved.

best estimate of the terminal value is thus the higher of the salvage value or the going concern value of about 6 times 2010 net income. Sea Kings federal-plus-state tax rate is 40 percent, and its weighted average cost of capital is 10 percent. However, the company is considering adjusting the WACC upward for projects with substantially more risk than average, and downward for less risky projects. Risk is estimated subjectively, although sensitivity and scenario analyses are used to help make the judgmental decision. There is no hard and fast rule as to how much to adjust the WACCthis is a subjective decision, but the CFO would like to lower the WACC by 1 percentage point for low risk projects and raise it by 3 percentage points for higher risk projects. Sea Kings director of capital budgeting (DCB) has developed a spreadsheet model designed to provide answers to such questions as, How low could the initial tons demanded be and still have the project break even? In accordance with Sea Kings standard practices, the DCB asked operating managers to provide her with a range for the key variables used in the analysis. She obtained estimates for the base case, or most likely value of each variable, good and bad values, and very good and very bad values. The base case value is assumed to have a probability of 50%, the good and bad outcomes 25% each. The values obtained are shown in the input section of the model and then used for the scenario analysis calculations. The model is relatively long, and the DCB warns that it might have a few bugs (errors), but it can be used to help analyze the project. You will need to check it for errors, though, before relying heavily on it. Assume that your consulting firm has been hired to evaluate the salmon project and to make a recommendation to Sea Kings executive committee. As noted above, Sea Kings DCB has a spreadsheet model that you can use in your analysis. Also, to help you structure your report, your boss at the consulting firm, together with Sea Kings financial VP, prepared the following set of questions that they would like you to consider and then discuss in a meeting with the Executive Committee. Questions About the Case 1. Why is Sea King considering branching out into the fish farming business? 2. What two alternatives are being considered for entering the salmon farming business? What is the approximate investment in fixed assets required to commence operations under each alternative? 3. What sunk cost is involved in the case, and how should it be handled? 4. What is the expected life of the project? How is the project life handled in the analysis? 5. What are real options? What two types of real options are embedded in the salmon project? Do these options apply to both the large and the small plants? In general terms, how do these options affect the expected profitability and risk of the projects? Can you think of any other types of real options that might be embedded in the project, or that might be developed? 6. How is the Excel model set up? How many tabs (worksheets) are in the workbook (file), and, in general terms, whats done in each worksheet? Questions that Require Detailed Analysis or Calculations Consider the land required for the salmon project. What land cost, if any, should be attributed to this project?

Copyright 2002 by South-Western. All rights reserved.

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Assuming that the site Sea king currently owns is used for this project, how should the Lobster Division obtain its required sitebuy now, buy later, or buy the option and then exercise it? What discount rate should be used to analyze the option? Now think about the other cash flows. If the project were undertaken, what would the R&D cash flows be in 2007 through 2009? Should any R&D cash flow for 2002 be included in the analysis? Explain. Describe how salvage values are taxed. Use the buildings salvage value to illustrate your answer. What are the expected NPV, IRR, MIRR, and payback for the large plant? For the small plant? Discuss the sensitivity analysis performed in the model for each of the plants. What does that analysis show? What are some weaknesses of the sensitivity analyses? Explain what scenario is and how it is used in capital budgeting. Also, explain how Excels Scenario Manager was used in the model. Explain what decision trees are and how they are used in capital budgeting. Also, explain how the scenario analysis can be used to help construct the trees. How are probabilities assigned to each of the branches? What is Monte Carlo simulation, how might it be applied in a capital budgeting analysis such as Sea Kings salmon project, and how might its results be used in the decision process. Now think about possible correlations between (a) each input variable over time, and (b) among the input variables. For example, would the level of demand in 2005 be dependent upon or independent of demand in 2004, and would the sales price and the quantity demanded be correlated or independent? Suppose sales in the first year that abandonment was possible were quite poor, suggesting that it might be best to abandon the project. Would it be easier to decide whether or not to abandon if the correlations were high or if they were low? Would a high correlation make the decision to expand the small plant harder or easier? Would high correlations make it more or less important to try to structure the project so that decisions could be made in stages? All things considered, would the salmon project be more or less risky if all correlations were high? (Hint: This is a tough question. There is no truly precise way to deal with possible correlations, but they are too important to ignore, so managers should and do think about correlations and consider them at least subjectively in their decisions.) Suppose most of Sea Kings projects have a coefficient of variation in the range of 0.5 to 0.7. How might that information be used in the analysis, and what effect might it have on the decision? What decision do you recommend for Sea Kingbuild the large plant, build the small plant, or dont enter the salmon farming business at all?

Copyright 2002 by South-Western. All rights reserved.