Frozen Food Products: Cost of Capital Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

Frozen Food Products: Cost of Capital Case Study Help

Introduction

Business expansion is an exhilarating pursuit, one that carries both great promise and considerable risk. Maria D’Souza, an entrepreneur with a legacy in producing tropical fruit pulp purees and concentrates, embarked on a journey to enhance her trade by presenting a novel merchandise track of frozen foods. The goal? To double the size and potential of her family-owned enterprise. Yet, amidst the excitement, lay the need for a precise financial assessment, particularly regarding the cost of capital, a linchpin in evaluating the feasibility of her expansion plan.

Determined to ensure her endeavor's success, Maria initiated a meticulous process. She projected earnings, expenses, and cash flows over a five-year horizon, with a focus on sustaining growth even after an initial high phase. At the heart of her endeavor was the quest for an appropriate discount proportion to ascertain the (NPV) of the project.

In seeking answers, she turned to industry analysis, drawing parallels between her business and those of similar companies in the food processing sector, leveraging the premise that firms sharing industry affiliations often carry akin risks and corresponding costs of capital.

Problem Statement

Maria D’Souza, the proprietor of a thriving tropical fruit processing business, is determined to expand her enterprise by venturing into frozen food products. The challenge she faces is the accurate determination of the cost of capital for this ambitious expansion. This vital financial metric will shape her ability to evaluate the feasibility and potential returns of her venture.

In the absence of readily available market data due to the private nature of her business, Maria must rely on comparative analysis with similar companies in the food processing industry to estimate her cost of capital. The problem at hand is to meticulously assess industry peers' financial data and leverage it to ascertain a reliable cost of capital, balancing ambition with financial prudence as she seeks to double the size and potential of her business.

Situational Analysis

Free Cash Flow of the Firm (FCFF)

The provided analysis offers a detailed financial perspective on the Frozen Food Project, specifically outlining the Free Cash Flow to the Firm (FCFF) over five years. This meticulous breakdown starts with Year 1, where the project generates an Earnings before Interest and Tax (EBIT) of $1,100. After accounting for a 30% tax rate and adding back depreciation, Year 1 produces a Free Cash Flow of $970. However, it's notable that Year 1 shows a negative FCFF value of ($17,373.37) when discounted to present value. This could be attributed to substantial capital expenditures and the associated tax implications.

As the project progresses, there's a clear upward trajectory. Year 2 sees EBIT rise to $1,255, leading to a positive FCF of $1,068.5. This trend continues through the subsequent years, with increasing EBIT and FCF. Beyond the five-year forecast, a terminal value of $18,300 is established, considering a 5% perpetuity growth rate.

The calculations factor in (WACC), which adjusts for the project's risk profile. While Year 1 may present a challenge, the positive FCF in subsequent years, combined with the terminal value, underscores the potential financial returns of the Frozen Food Project.

Appropriate Rate for Discounting FCFF

The determination of the appropriate rate for discounting (FCFF) is a crucial step in evaluating the profitability of the Frozen Food Project. While the current Risk-Adjusted (WACC) is set at 10.60%, the discount rate for FCFF must remain lower than (IRR) and (MIRR) to ensure profitability. A higher IRR compared to the cost of capital acts as a safety margin for the project's financial sustainability.

Since the Frozen Food Project represents a new venture in the company's portfolio and is not publicly listed, determining its beta for risk assessment becomes challenging. To incorporate the unique business risk of this new project, a comparable business about fiscal gearing and operating in the same industry that Maria D'Souza aims to enter is employed as a reference.

For this purpose, Venky’s India Ltd. is selected, as it closely matches the prearranged “debt-to-equity” proportion for the frozen food project. By utilizing Venky’s India Ltd. as a reference, a new discount rate is calculated, as seen in Exhibit 2, aligning the rate with the specific business risk associated with the Frozen Food Project. This adjusted rate ensures a more precise assessment of the project's profitability and financial sustainability..........

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