7Project Evaluation: Tortuga Fishing EquipmentCompanyJudson W. RussellAbstractThis case study on project evaluation is applicable forbeginning courses in corporate finance or finance strategy. Twoalternative investment options are available to evaluate.Challenges are presented with the inclusion of equity, bank debt,and bonds in the capital structure. Each investment option need tobe evaluated carefully and decision should be made on the basis ofthorough analysis of the data available using various capitalstructure and capital budgeting techniques.Keywords: Beta, Corporate Finance, Cost ofCapital, Internal Rate of Return, Net Present Value JELCode: C10, G31, G32IntroductionBrooks Hamilton recently accepted a job with Tortuga FishingEquipment Company[1] (Tortuga) in thecompanyAc€?cs finance department. His first few assignments were fairlystraightforward and Brooks relied on his background in bothaccounting and finance to get his career off to a great start. Hismanager, the companyAc€?cs Chief Financial Officer (CFO) was impressedwith his work and decided to put Brooks on a new assignment. Thefirm was embarking on a new project which would define its futureover the upcoming years. Given the importance of the project andhigh degree of visibility with the firmAc€?cs senior management, Brookswas flattered to be asked to assist and eager to show that he wasup to the task. The finance department was tasked with preparing ananalysis to make a decision between two competing project planswhich could very well decide the future of Tortuga in thecompetitive fishing equipment industry. The Chief Executive Officer(CEO) wants to have an answer from finance and expects a thoroughanalysis very quickly.The CompanyTortuga is an Islamorada, Florida based company specializing inmanufacturing high-end fishing rods and reels. Tortuga was foundedby a retired university professor who fished all of his life andwanted to create the best equipment possible to handle a variety offishing conditions and fish species. He partnered with an engineerwho ran a machine shop to produce some prototype reels and suppliedthese to commercial fishing captains as test market research. Theequipment produced by Tortuga was a significant improvement overthe current line available and orders were strong. Through theyears, the company made some modest improvements to their originalprototype and had become an industry leader. TortugaAc€?cs products are used by tournament fishing teams aroundthe world. Over the past decade, tournament fishing has grown tobecome a big business with corporate endorsements and prize money.This growth has made what was once a recreational vocation into afull-time profession for some anglers. The company recently launched an extensive research anddevelopment effort focused on a new flyrod and reel designed forone particular species of fish, the Atlantic Tarpon (Megalopsatlanticus). Tarpon are long-lived fishes that migrate in thewarmer climes of the Caribbean Sea, Gulf of Mexico, and along theAtlantic Ocean coastlines. Although the fish can reach lengths ofeight feet (~2.4 meters) and weights of 280 pounds (127 kilograms),they inhabit the shallow flats and exhibit acrobatic leaps whenhooked. These traits make tarpon a popular game fish for anglers.Fishing gear needs to be sturdy to handle the power of these fishand Tortuga had developed products for this niche market which wereallowing anglers to be successful in their angling pursuits.Recently, several sponsors had come together to launchcompetitive angling events called tournaments, where the bestanglers vie to catch, and then release, the most and largesttarpon. Winners may receive up to $50,000 in a single weekendtournament and the difference between winning and losing could be afew pounds. With so much money at stake, tournament teams purchasethe best gear available and are always looking for any competitiveadvantage with their equipment. Tortuga is looking to capitalize onthis trend by offering a new line called the Tortuga TarponClassic. This new line incorporates the latest material and designimprovements and is predicted to be the Ac€A?gold standardAc€?? for allserious tournaments anglers. Tortuga plans to offer the TortugaTarpon Classic to recreational anglers as well to capture thegrowing demand by affluent anglers who want the same high-qualitygear as the professionals.Financial InformationTortuga began with a modest amount of capital that the founderhad managed to save during his years in academia. As the firm grew,its financing needs expanded as well. Through the years Tortuga haddeveloped and maintained a strong relationship with a large bankwhich provided short-term working capital funds in the form of arevolving line of credit. When a funding need arose, Tortuga woulddraw from this line of credit and then repay the short-term draw ascash flowed back to Tortuga. The $200 million revolving line ofcredit currently has $25 million drawn at an interest rate of3-month Libor plus 350 basis points[2]. Theremaining $175 million credit line can be assumed to have no feesassociated with it[3]. Brooks looks up themost recent 3month U.S. dollar Libor rate and sees that it is1.50%.Long-term financing was also in place in two forms. Afterseveral years of revenue and earnings growth, Tortuga issued fivemillion shares of common stock at an issue price of $10 per share.The firm used this $50 million in funding to increase productionlines and build a global presence by opening an additionalmanufacturing facility in Panama. Brooks finds the current priceper share for Tortuga to be $16. Two years ago, Tortuga issued a10-year bond for $50 million face value. Each $1,000 par bondcarries a coupon of 8.5%. The bond pays interest semi-annually andis currently trading in the market at 102.50 as a percent of par.The company has a 34% corporate tax rate.The firm calculates its required return on equity with theCapital Asset Pricing Model (CAPM) using a 4.0% historical Treasuryrate for the risk-free rate and 6.0% as the historical market riskpremium[4]. CAPM = Risk-free rate + beta(Market Risk Premium) (1)The annual stock returns versus the market are shown in Figure 1below for the past 10 years. Beta is calculated by regressingTortuga stock returns on the Standard & PoorAc€?cs (S&P) 500returns. There are a variety of methods for calculating beta.Brooks could find beta by regressing five years of weekly Tortugareturns of the S&P 500. He could use five years of monthlyreturns or two years of weekly returns. Each of these is a validsample period. One well-known data source provides an Ac€A?adjustedAc€??beta which is determined by first calculating a Ac€A?rawAc€?? beta byregressing two years of weekly security returns on the market. Thisis then adjusted by taking 2/3 of the raw beta plus 1/3 of one.This adjusts the beta to be closer to one, since beta is notstationary and should naturally move towards one through time as afirm expands. Brooks only has 10 years of annual data available atthe time and decides to conduct the analysis with this informationto get a quick response. He will check his result with more datapoints before submitting his final report to theCFO. Figure 1 Returns on Tortuga Stock versus the Standard & Poor500YearTortuga returnS&P 500 return1127222163-2-3414959861921716178-10-5979101214After Brooks calculates beta he employs formula (1) above alongwith the risk-free rate and market risk premium to determine thecost of equity. The firmAc€?cs weighted average cost of capital is afunction of its equity market capitalization, cost of equity,short- and long-term debt amounts and costs, and the tax rate.Using formula (2) below, Brooks can find the firmAc€?cs weightedaverage cost of capital (WACC).WACC = wdkd(1-T) +weke where:WACC= weighted average cost of capitalwd = weight of debt to total capital (note: this includes short-and long-term)kd = cost of debt using yield to maturity and current values forshort-termT = corporate tax ratewe = weight of market capitalization to total capitalke = cost of equity determined with CAPMTortuga Tarpon ClassicThe company has two separate research teams working on theproject and they develop two distinctly different fishingcombinations. The two rod and reel combinations are test marketedwith guides and past tournament champions and demand forecasts aredetermined. Most fishing gear has a relatively short life due tocontinual product innovation. Manufacturing of the two combinationsis estimated to require an upfront cost of $5 million to retool themachine shop. The process for manufacturing the two combinationsdiffer and ongoing variable costs are not the same. The net cashflows for the entire ten year expected life of the product is shownin Table 2 as Project A and Project B (all figures are $thousandsof net cash flow). Project A focuses on hand tooled fishing equipment which resultsin a more labor intensive process, but also allows for personalizedfeatures for customers. The price charged for customization offsetthe slower hand tooling process to generate substantial net cashflows. Part of the upfront $5 million includes the costs oftraining more machinists in the art of hand tooling, which issimilar to watch making but with a few less moving parts. Project Ais anticipated to generate lower cash flows in the early years dueto the length of time required to get machinists who are adept athand tooling to customer specifications. In fact, during the firstyear there will be continued expenses to attain these skills whichcauses year one net cash flows to be negative. Over time the cashflows increase as more machinists gain proficiency. The project isexpected to experience lower cash flows towards the end of its lifedue to market saturation. Due to the quality of the reels, they arebuilt to last and seldom fail or wear out. Technologicalobsolescence is certain although Tortuga will be investing cashflows into research and development to launch the next generationat the conclusion of the Tortuga Tarpon Classic life cycle.Project B employs a mechanized approach to large scaleproduction of standardized equipment. Although the approach doesnot allow for personalization, it does allow Tortuga to build itsinventory quickly and capture positive net cash flows immediately.The upfront expense is almost completely devoted to toolingequipment procurement and the number of units produced will be muchhigher and at lower price points than the approach of Project A. Atthe end of both projects life it is assumed that there will be zerosalvage value as the pace of innovation will require a completere-tooling for the next generation and the useful life of theequipment will have been fully realized.Brooks realizes that he will need to calculate the firmAc€?cs costof capital discount rate and apply this to the cash flowprojections of both projects. He recalls all of the assignments hecompleted at university and is thankful to have been sowell-prepared for this task. He gets a cup of coffee, sits down athis desk, and gets to work.Figure 2 Project Net Cash Flows for Tortuga Fishing Equipment($thousands)yearproject Aproject b1-900950220095039009504180095052500950625009507180095081200950980095010200950Since Brooks is new to his role, you have been asked to reviewhis work and assess the financial viability of the projects. Giventhe importance of this decision you are helping to make sure thefirm makes the right choice. Specific Questions1.Using the Capital Asset PricingModel, what is the required rate of return on equity, ke(cost of equity) for Tortuga?2.Analyzing the companyAc€?cs bond,what is the yield to maturity on the bond issue, kd(cost of debt)?3.Using the market weight ofequity, the original issue amount of debt, and the outstandingportion of the revolving line of credit, what are the weights ofequity and debt in the capital structure (we &wd)?4.Using the information provided,what is the firmAc€?cs weighted average cost of capital (WACC,ka)?5.What are the net present value(NPV), internal rate of return (IRR), and Payback Periods forProjects A & B?6.What decision rules will you useto help Tortuga reach a decision?7.What are the strengths andweaknesses of each of the evaluation tools?8.What do you suggest toTortuga?AuthorJudson W. Russell, Ph.D, CFAClinical Professor of Finance, Belk College of Business,University of North Carolina Charlotte,|!