Case study - Clear Lake Bakery - Capital Budgeting
QUESTIONS
1. Calculate the yield-to-maturity for the mortgage bond.
2. Estimate CLB's cost of equity
3. What is the firm's overall cost of capital?
4. Find the net cash flows for the automated mixer.
5. Calculate the net present value for the automated mixer project.
6. What is the internal rate of return for the mixer?
7. Determine the net present value of the continuous oven.
8. Determine the net present value of the semiautomated packing unit.
9. Which capital projects should Mike undertake this year?
Clear Lake Bakery: Capital Budgeting
Background
- Mike Ulig, fourth-generation owner, is considering ways automate his baking operation accommodate the increase in demand and reduce labor costs
- He is considering 3 projects:
o An automated mixer
o A continuous baking oven
o A semi-automated packing unit
- Clear Lake has seen a tremendous increase in demand for its cookies, mostly from mail order sales
- The method of making cookies is similar to making them at home, but the scale is much larger
- Only two family members know the secret recipe for making these cookies
- Shares of Clear Lake Bakery have a current market price of $27 per share
o This year the company paid a dividend of $1.215 per share
- Earnings and dividends have been growing at a constant rate of 8% per year and are expected to grow at the same rate into the foreseeable future
- The company has a mortgage bond with an 8% semi-annual coupon that matures in 10 years
o Currently selling at a discount for $875
- The company's marginal tax rate is 35%
Issue
- As part of planning for the next year, Mike is evaluating three pieces of equipment as previously described
o Each should be considered as a separate, independent project
- Considering his projected earnings and borrowing capacity, Mike thinks he can commit $1,000,000 to capital projects in the upcoming year
- Automated Mixer (will replace an old mixer)
o Will result in a 500 lb increase in the amount of cookie dough that can be mixed per day
o It will cost $240,000 including installation
o The old mixer has been fully depreciated and has no market value but will be retained as a backup mixer
o The new mixer is expected to increase revenue by $62,500 per year and decrease expenses by $22,500 per year
o Both revenues and expenses are expected to increase by 5% each year
o The new mixer will be depreciated on a 3-yr MACRS to salvage value of $0 (salvage value at end of 5-yr economic life is also $0)
o Mike will replace the new mixer after 5 years
o The increase in production of cookies can be stored in the unused portion of the warehouse
The value of the average increase in cookies stored will be $16,000; A/R will increase by $4,000, and A/P will increase by $6,000
- Continuous Baking Oven
o The new oven would cost $685,000 including shipping and installation
o The new oven would replace the 6 roll-in ovens that are currently being used
o There would be no increase in capacity, but there would be a savings in operating expenses of $105,000 per year
He expects that these expenses would have increased by 5% per year for the 10 year economic life of the oven
o The new oven would be depreciated using 7-yr MACRS to a value of $0, but Mike thinks he can sell the oven in 10 years for $30,000
- Semi-automated Packing Unit
o This would cost $390,000 including installation
o It would be depreciated using 7-yr MACRS
o The economic life of the packer is 10 years at which time it would have zero market value
o Currently there is a wrapping machine that was purchased 4 years ago for $90,000 and is being depreciated using 7-yr MACRS
The wrapper has a current market value of $20,000
o The new packing unit will result in savings in operating expenses of $90,000 per year
These expenses are expected to increase by 5% per year over the 10-yr economic life of the unit
Things to Consider
- When calculating the WACC, determine the Market Value capital structure
o MV Debt:sales price / 1000 par value * $ outstanding
o MV Equity: # outstanding shares * $ / share
- When determining the net free cash flow, first determine the equipment's depreciation schedule using Exhibit 2, then calculate the FCFs for each relevant year
o Free Cash Flow = EBIT*(1-T) + depreciation - CAPEX - Change in NOWC
EBIT = Change in operating income - depreciation
o Remember, economic lives are as follows:
Mixer: 5 years
Oven: 10 years
Packer: 10 years
Don't forget to include initial investment, changes in Working Capital, salvage value, and changes in asset depreciation into account
For packer, need to consider net change in depreciation and tax savings from disposition of wrapping equipment
Attachment:- Case Study.pdf