Socially Responsible Capital Budgeting Project:
In this assignment you take the position of an analyst working within a large clothing designer / manufacturer / retailer. Your company has developed an e-ink usable in cloth and it intends to maintain the recipe and production process as a trade secret. This, combined with the somewhat complicated nature of the technology, requires that rather than outsourcing the production of garments including the technology your firm will be required to manufacture them in house. You are tasked with determining which of three potential geographic locations for the new plant best serve the interests of the firm and its stakeholders or if e-ink products should not be brought to market based on revenue and cost projections. In addition there is potential in some locations to move forward with some of the firm's sustainability agenda and source the power from the plant using wind or solar energy.
You estimate that your product will have a six-year life span, and the equipment used to manufacture the project falls into the MACRS 5-year class. The resulting MACRS depreciation percentages for years 1 through 6, respectively, are 20%, 32%, 19%, 12%, 11%, and 6%. Your venture would require a capital investment of $160,000,000 in equipment, plus $10,000,000 in installation costs. The venture will increase accounts receivable and inventories of $30,000,000. At the end of the six-year life span of the venture, you estimate that the equipment could be sold at a $50,000,000 salvage value. Your venture would incur fixed costs of $10,000,000 per year, while the variable costs of the venture would equal 30 percent of revenues. You are projecting that revenues generated by the project would equal $50,000,000 in year 1, $130,000,000 in year 2, $150,000,000 in year 3, $160,000,000 in year 4, $110,000,000 in year 5, and $80,000,000 in year 6.
The following list of steps provides a structure that you should use in analyzing your new venture. Note: Carry all final calculations to two
decimal places.
1. Find the costs of the individual capital components:
a. long-term debt
b. retained earnings (use DCF approach)
2. Determine the target capital structure weights
3. Determine the marginal tax rate.
4. Determine the weighted average cost of capital.
5. Compute the Year 0 investment for Project I.
6. Compute the annual operating cash flows for years 1-6 of the project.
7. Compute the non-operating (terminal) cash flow at the end of year 6.
8. Draw a timeline that summarizes all of the cash flows for your venture.
9. Compute the IRR, payback, discounted payback, and NPV for each location.
10. Prepare a report for the firm's CEO indicating which locationif any should be accepted and why, including careful explanation of tradeoffs and concerns in non-financial factors.
11. Assign dollar heuristics to pertinent non-financial factors and determine whether your recommendation in 10. is consistent with heuristics using the NPV criterion.
The first of the three locations your company is considering locating its factory is in Waterloo Iowa. Waterloo, while far from company headquarters in New York, is most appealing in that it is accepting of manufacturing and has a capable workforce yet is in close proximity to Cedar Falls with a high education level. Since the plant will be a mixture of high technology and textile manufacturing this feature of the location is appealing. With clothing manufacturing increasingly being done overseas, if Waterloo is chosen the firm believes that it will generate some customer goodwill toward the brand and help with currently tough negotiations with unionized employees elsewhere in the company. The Ceder Falls / Waterloo area has recently undergone terrible flooding and so a move into Waterloo would provide an opportunity for the firm to help with the rebuilding effort there. Since production facilities will be located in the same country as headquarters, management is not concerned about quality creep for this location as they can afford to do regular inspections there. Since there is less uncertainty in construction within the continental United States this version of the project will have a 0.7% smaller weighted average cost of capital than is typical for the firm. This plant can also be constructed to use 60% of its electricity using wind turbines at an additional cost in present value terms of $24,000,000
Disadvantages to Waterloo are no special federal tax incentives, although the city government grated a 10 year waiver of property tax on any facility constructed there. More important is the significantly higher costs to operating the factory within the continental US. Fixed costs are $10,000,000 per year and variable costs are 40% of revenues.
The second potential location for the manufacturing plant is in Manaus Brazil. Manaus is in the Amazon River basin at the confluence of two major rivers. It is a large, booming city of over a million residents. The Brazilian government is concerned about the economic development of rural Brazil and has offered generous tax incentives to businesses located within the Manaus Free Trade Zone (FTZ). Building the factory in Manaus will help provide economic opportunities for local residents, although the Brazilian economy is going quite well and growing quickly. Brazil is currently experiencing 7.1% unemployment, significantly less the United States. Due to distance the New York office is concerned that quality oversight will be difficult and being a luxury brand they are sensitive to having it tarnished. They estimate a 5% chance that quality issues will prevent the product from going forward after the factory is built (in that case no revenues will be generated and the plant sold at salvage value ($50,000,000). The regulatory environment is stable in Brazil, especially in the FTZ, but the Continental US is probably safer. Management sees the factory being in such a hot economic growth area as a plus. Brazil has a 34% corporate tax rate but companies operating out of the Manaus FTZ receive a 75% exclusion. US corporate income taxes will need to be paid when those earnings are repatriated but often this decision can be delayed until a tax holiday is granted. Fixed costs are $10,000,000 per year Manaus and due to lower wages, variable costs are 30% of revenues.
A major concern with the Manaus facility is potential indirect damage to the Brazilian rainforest. Manaus is located near major rainforest areas and economic development of the region will generally lead to deforestation. The plant itself will not harm any forest nor will any buildings associated with it, but the public relations office is concerned perceptions of economic damage may harm the brand. The potential exists though to work in partnership with local governments to develop a nature preserve of some kind but the firm has not investigated this option in any detail. Management perceives this location to be effectively riskier than the other two and suggests a project specific increase in WACC of 0.9%. This facility also has a "green" option although wind energy is not plentiful there. For a present value of $22,000,000 70% of the plants energy can be sourced from solar panels manufactured in China. This would significantly increase the land use of the project however.
The third potential location is the Northern Mariana Islands. These pacific islands were strategically important to the US in World War II and remain US possessions to this day. Legally they represent an interesting middle ground between US and non-US operations. While part of the US, the islands were allowed to set their own immigration policy and had an extensive guest worker program, drawing workers from South East Asia and China. The islands are currently in economic disarray. Due to scandals involving the treatment of guest workers by the local government and employers most of the established garment manufacturers have completely pulled out of Saipan. Between 2002 and 2007 total payroll to manufacturing workers dropped from $185 million to $57 million as factories were shuttered. Citizens that grew accustomed to generous paychecks from positions in city government are now facing new fiscal realities.
There are many skilled workers that are unemployed and garment factories ready but unused. Consequently, the initial outlay to build here is $80,000,000 less than in Manaus or Waterloo. Due to the depressed nature of the economy in the islands bringing production there would have a large effect on the local economy and generate significant goodwill with the locals and remaining guest workers, especially if the firm were to pay the US minimum wage rather than the local minimum wage. Fixed costs there are $10,000,000 per year and variable costs are 35% of revenues. Due to the great distance and the use of older equipment, the chance quality never gets up to snuff is 10% rather than 5% in Manaus and salvage value of the machines and plant is $40,000,000 rather than $50,000,000. There is concern that the public will perceive a return of a garment company to Saipan as an invitation to return to abuse of guest workers although the company is confident in its ability to treat the guest workers fairly. Due to the remoteness of the Northern Marianas neither green option will be available there. The tax rate is 35% but due to rebates the effective rate is 17.5% on repatriated income. Management believes this location would product a project of typical risk and the usual WACC would be appropriate. Clothes made in this facility would be "Made in the USA" for labeling purposes. There is some regulatory uncertainty with respect to the local government, somewhat more so than in Manaus and significantly more than Waterloo.
Attachment:- Capital_Budgeting_Project_Format.xlsx