Capital budgeting with staged entry: Atlantic aquacultures inc.

Table of Contents

1. Introduction

2. Questions

3. Appendix
3.1.1 Appendix A1: Q2c - Cash flow statement large plant, high growth & initial demand
3.1.2 Appendix A2: Q2c - Cash flow statement small plant, high growth & initial demand
3.2 Appendix B: Q3 – NPV, IRR, MIRR, Payback
3.3 Appendix C: Q4 – Without abandonment option
3.4 Appendix D: Q8 – Updated probabilities
3.5.1 Appendix E: Q9 – Graph for sensitivity analysis
3.5.2 Appendix E: Q9 – Table for sensitivity analysis
3.6 Appendix F: Q10 – Scenario analysis

4. References

1. Introduction

In 1996, the board and senior executives of Atlantic Aquaculture, Inc., arranged a meeting considering a major change in its corporate strategy. Atlantic Aquaculture has been a market leader ever since in the seafood industry. However, due to increased competition, in particular from low-cost foreign producers, they are forced to reconsider their strategy. Furthermore, the U.S. experienced slow economic growth resulting in massive layoffs, which consequently made the consumer more price-sensitive with their fish selection. Additionally, the demand for freshwater fish, such as trout, has been increasing over the years. Hence, the freshwater market provides an excellent opportunity to recapture market share in the seafood industry. In the upcoming questions, we will analyse which strategy they should pursue and whether the freshwater market provides a good investment opportunity.

2. Questions

1A) Several years ago, Atlantic acquired a tract for $300,000, which could be used for the project. If they do not want to use it, they could sell it for a price of $900,000, after real estate brokerage fees and taxes. However, other suitable sites could also be purchased for the same price. Hence, the cost that should be assigned to the project is $900,000 and can be seen as opportunity costs. In addition, Salmon Division purchased the tract currently owned. Nonetheless, if the site is used for the trout project, Atlantic should consider purchasing an similar piece of land for Salmon Division by year 2000. Therefore, Atlantic can acquire an option on a similar site in the same area for a cost of $60,000, which has to be paid on December 31, 1996. Consequently, Atlantic has the right, but not the obligation, to purchase the site on December 31, 2000 for $1,000,000.

1B) For the comparison of two values, they have to be in the same year; otherwise they have to be discounted accordingly. In our case the Salmon Division should obtain the site at the end of 2000 (t=4) and hence, the value of current site has to be appreciated accordingly. In 1996, the value of the site amounts to $900,000 and with an appreciation rate of 6%, the site will have the following value: . Afterwards the actual gain of the option can be calculated: However, the option itself was purchased at $60,000 and therefore has to be subtracted: . As a result, Atlantic will make a profit of $56,449 when they use the option instead of buying the site today. Since the investment in the project at year 0 is certain, the risk-free interest rate serves as a good discount rate.

2A) In total, Atlantic has spent $600,000 on R&D on the trout project, but $240,000 has been expensed for tax purposes. Taking Atlantic’s federal-plus-state tax rate of 40%, the cash outflow amounts to $144,000 ($240,000*(0.6)). The remaining cost of R&D will be amortized over the first three years of the operating life of the new facility. Cash inflow will therefore be $48,000 ($360,000*0.4/3).

2B) According to Brigham and Daves (2009), if a depreciable asset is sold, the sale price (actual salvage value) minus the then-existing depreciated book value is added to operating income and taxed at the firm’s marginal tax rate. Both building (L and S) fall into the MACRS 31.5-year life and will be depreciated during 1998. For illustration, we will only consider plan L which has a salvage value after 7 years of $2,328,000 due to the following calculation ($3,000,000-($3,000,000*0.032*7)). Furthermore, the buildings could probably sold for about half the book value, which leads to $1,164,000. Afterwards this loss is tax deductible with the marginal tax rate of 40% amounting to $465,600, which increases cash flow to the stated amount.

2C) See Appendix A1 & A2.

3) The following results are based on input data at the top end of the estimates, because the VP estimated an 80% probability of further high growth if initial demand is high. With a WACC of 9%, since the project has average risk, and a initial demand of 10.000 units with a growth rate of 14.4%, consisting of a 10.4% growth rate and 4% inflation the NPV, IRR, MIRR and payback results are as displayed in the appendix B.

4A) From the starting point, one branch goes up indicating high initial demand (=10.000) with a probability of 0.75 and one branch goes down indicating low initial demand (=5.000) with a probability of 0.25. The left column of the decision tree represents this. If the initial demand is high, the growth rate is expected to be 10% with a probability of 0.8 or to grow at 2% with a probability of 0.2. If the initial demand is low, the probability for high and low growth rates are reversed. This is shown in the second column of the decision tree. Cash outflows occur, as shown in parentheses, in the first two years if initial demand is high. If initial demand is low, the cash outflows range until 2001 and for a low growth rate until 2003. All other cash flows are positive. However if initial demand is low, the firm has the possibility to abandon the project (put option) after two years of operations, at the end of 1999. The NPV is generated at the end of each cash flow series. Afterwards the NPV is multiplied with the joint probability resulting in the product of probability and NPV. The latter is then added up for each case to examine the total expected NPV. This expected NPV shows whether the project is profitable or not. However, the standard deviation (later referred to as: SD) also has to be taken into account since it measures the risk of the project. Hence, the higher the SD, the more volatile and therefore riskier the NPV of the project is. According to Brigham and Daves (2009) “the Coefficient of variation (later referred to as: CV) shows the risk per unit of return” and can be calculated by dividing the SD by the expected NPV. In our case, it is 1.15 indicating that the project is slightly riskier than the average project.

4B) Abandoning a project can be viewed as a put option meaning that if the demand is not as expected one could abandon the project at an exercise price to hedge against further losses.

In our case, the abandoning option can only be exercised at the end of 1999 due to contractual restrictions. If the demand is low, Atlantic should exercise the option to prevent further losses, which are indicated by the following negative cash flows. The abandonment would be associated with a positive cash inflow due to sale of equipment and buildings at half of their book value, and the land at its appreciated cost. The product terms are based on abandonment, because continuing the project yields even more negative NPVs, namely -$6,939 and -$9,316 for high growth and low growth respectively.

4C) If the possibility of abandonment is ruled out, the risk would increase and the expected NPV would decrease. In particular, the NPV decreases to $10,284 with a SD of $11,189 and a CV of 1,32 (Appendix C).

5A) Considering the small plant plan, Atlantic has the opportunity to exercise the real option in 2000, by expanding their capacity. As a result more branches in the decision tree are added, because every time they have the option to expand or not to expand.

5B) First of all, it should pointed out that each branch can only have one joint probability and product, because the company can either expand or not expand, but not both at the same time (p = 1). Furthermore, the expansion is only considered, if the initial demand and the growth rate are high (upper branch). If the growth rate is low, the no expansion option is the better alternative, because it has a positive NPV of $7,633. The expansion would have a negative NPV because of the additional investment in 2000. If the initial demand is low, neither expansion nor abandonment is an option, because continuing operations with the small facility (no expansion) yields the highest NPV in case of a high growth rate $4,524, and in case of a low growth rate -$1,717.

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