Pleasure Craft Inc. Case Analysis Harvard Case Solution & Analysis

Cons:

The most significant disadvantage of debt financing is that the debt will have to be repaid at an agreed time in the future and interest will also have to be paid on the outstanding amount of the debt over the entire period of debt. The debt raised is usually secured on the business assets and property and failure to repay the debt can cause the liquidation of the businesses. In other words, debt financing is the borrowing of the funds against the future earnings of the company. Overuse of debt financing can stifle the growth of the company and cause financial problems.

Equity

The third financing source for the company is equity financing. The pros and cons of this financing method are:

Pros:

The main advantage of equity financing is that equity will not have to be repaid in future. The risks of the business and its liabilities are also shared with the new investors of the business. Since, equity is not repaid,therefore the cash flow generated could be utilized to grow the business in future.Lastly, maintaining low debt to equity ratio strengthens the financial position of the company.

Cons: The main advantage of equity financing is that when the company issues equity, control is lost and the earnings per share is diluted. The decision making authority for the business is also transferred in the hands of new investors partially. A portion of the profits will also have to be paid to the new equity investors. These distributed profits could exceed the interest paid on debt over time which makes it risky for the company. Finally, equity is more risky than debt financing.

Recommended Financing Mix

Since both the projects which are being considered by PC Company are significant in size therefore, the company would not be able to fund them through internally generated funds. Moreover, the company has to make $ 5 million investments from the current year capital budget for mandatory renovations on its current equipment and buildings to comply with the health and safety regulations. Therefore, the recommended financing mix for PC Company to fund these projects would be to raise the required financing through a combination of debt and equity financing. The target debt to capital ratio for the company is 30%/70% for debt and equity, therefore, we assume that 30% of the project amount would be raised through debt and 70% through equity. Based on this assumption, the floatation costs of financing both the projects through a combination of debt and equity would be:

FLOATATION COSTS
ProjectFront-End LoaderOutboard Motor
Financing Required18.1815.72
Cost of Issuing Equity8%8%
Cost of Issuing Debt3%3%
Equity Weight70%70%
Debt Weight30%30%
New Equity to be Generated2020
Total Floatation Costs for each Project5.99%5.30%

The financing required for Front end loader project is high therefore, its floatation costs are also higher as compared to that of Outboard Motor Project.

Evaluation of Overall Strategy

In this section of the report we perform an evaluation of the overall capital budgeting strategy for PC Company and then make a final recommendation to the management of PC by evaluating the above qualitative and quantitative factors for both the projects.

The current growth of the company has stopped since, both the current business segments of the company have reached to a point of saturation. Therefore, investment in one of the projects from the above two projects is mandatory for the company to sustain the long term growth of the company. The case states that if the projects are viable and feasible, then the management of PC can pursue to invest in both the projects. Therefore, first of all, we should evaluate the option of investing in both the projects.

Investing in Both Projects

Both the projects are of a large size and scale and the net present value for both the projects are positive. However, there is a huge gap between the net present value of the front end loader and the outboard motor project. The different between the internal rate of return of the two projects is also significantly high. Therefore, the management of PC could undertake both the projects.

However, if the management undertakes both the projects, then the total financing required for both the project would be equal to $ 18.18+$ 15.72= $ 33.90 million. This is a huge capital budget. The management of PC expects to raise $ 20 million of the funds through equity issue. Therefore, the remaining financing of about $ 13.90 million will have to be issued through debt financing. Raising such huge financing amount through debt might distort the current target capital structure of the company and increase the cost of capital for the business. The total weighted average floatation cost for raising this financing amount would be 10.39%.

Investing in a Single Project

If the management of the company undertakes a single project, then the company would be able to manage both the projects and the management would not face any burden. This would also reduce the burden of tax on the company’s capital budget. The floatation costs for financing Outboard Motor project would be lower than Front End load project as discussed previously. Finally, the sensitivity analysis has been performed for both the projects before making a final recommendation to the management of PC.

Sensitivity Analysis for Front End Loader Project

The sensitivity analysis for the front end loader project has also been performed by generating the best case and the worst case scenarios. If the debt proportion in the capital structure increases by 20%, sales growth for first 5 years increase by 5%, beyond 5 years 2%, the inflation rate decreases to 1% and discount to municipal and military clients is reduced by 5%, then the NPV of this project would improve significantly and reach to a level of $ 191.89 million with an IRR of 94%.

However, for the worst case scenario,if the debt proportion in the capital structure decreases by 5%, sales growth for first 5 years decrease by 5%, beyond 5 years 2%, the inflation rate increases to 3% and discount to municipal and military clients is increased by 5%, then the NPV of this project would decline and reach to a level of $ 101.93 million with an IRR of 79%.

Sensitivity Analysis for Outboard Motor Project

The sensitivity analysis for the Outboard motor project has also been performed by generating the best case and the worst case scenarios. If the debt proportion in the capital structure increases by 20%, sales growth for first 10 years increase by 5%, beyond 10 years 2%, the inflation rate decreases to 1%, then the NPV of the project would improve significantly and reach to a level of $ 27.03 million with an IRR of 24%.

However, for the worst case scenario,if the debt proportion in the capital structure decreases by 5%, sales growth for first 10 years decreases by 5%, beyond 10 years 2%, the inflation rate increases to 3%, then the NPV of the project would decline and reach to a level of $ 6.32 million with an IRR of 18%.

Recommendation to Jane Meadow, VP of Operations

After analyzing the financial numbers and the qualitative factors for both the capital projects, there are benefits and risks with both the projects. For instance, for the Front End Lead Project 50% of the total sales would also be made to the military and the municipal governments but at a discount of 15%. Moreover, there is no discount for the Outboard project and its initial costs are low. Based on NPV and IRR both the projects could be undertaken by the management.

However, considering the qualitative factors, the use of financing mix, floatation costs and the advertising and sales experience for Outboard Project, the best choice for PC Company is to invest in Outboard Motor Project. This project is also similar to the current market of PC and its products are also similar. No new sales experience is required for this project and the risk of this project is also low. Therefore, considering all these factors PC management is recommended to invest in Outboard Motor Project.......

 

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