FIN 319 – Case #1
Fitness Inc. (FI) is a sportswear company that designs and manufactures an extensive line of fitness and recreational sports clothing for consumers. FI is considering launching a line of athletic shoes next year to compliment their current product offering. The athletic shoe market is very large but is also dominated by a small number of well known companies. FI has already invested $15 million in research and $5M in test marketing and believes their product will be competitive with product offerings from other companies. You have been approached by the president of the company to analyze the proposed project and make a recommendation on whether FI should launch the initial line of athletic shoes or not.
In the current year 2.5 billion pairs of shoes are expected to be sold in the United States and forecast to grow at 3% per year. Of that total, 15% of the sales are classified as athletic shoes. Being a new entrant to the market, FI expects to get a 1% share of the athletic shoe market in the first year of sales and that share will grow by 0.5% each year. FI’s first product line is expected to be sold for 5 years, in the 6th year FI plans to transition to a second generation of shoes. In that 6th year half of the sales are expected to
be comprised of the initial product line and the other half comprised of the second generation. Athletic shoe prices currently average $45 / pair and are expected to increase in price by 2% per year. The company is fairly confident in most of its projections, but market share and price are the two items with the most variability.
The variable cost of goods sold is forecast to be $35 / pair at time of product launch and is forecast to decrease by 2% / year as the company gains experience with the manufacturing process. Selling, general and administrative expenses are expected to be 15% of sales.
Prior to launching the new product line, FI will need to spend an additional $70 million on R&D over the next two years to complete the design ($35M each year), $15 million on test marketing and $120M on capital equipment to support the manufacturing process. The equipment purchase and test marketing will be done one year prior to the start of sales. The equipment will be depreciated using the seven year MACRS schedule. The equipment will have a $25 million salvage value after all sales of the initial product line have been completed. Also, the company will need to invest $15 million in net working capital prior to the first year of sales. Once sales begin the company will plan to maintain 30 days of
accounts receivable, 45 days of inventory and 35 days of accounts payable.
The corporate tax rate is 40%. To establish a discount rate, you believe VF Corp’s (VFC) current weighted average cost of capital (WACC) is the best proxy to use. Please calculate VFC’s WACC to use as the project discount rate.
In your recommendation please include the payback period, NPV, IRR, MIRR and profitability index.
Case info from the syllabus
The primary purpose of the cases is to obtain experience applying the concepts and frameworks discussed in class. Concepts often seem clear when initially discussed but can break down during application due lack of a robust understanding, inconsistency of data, difficulty in estimating required parameters, and interpretation of results to
name a few. In addition, the project will also provide practice in financial research, business acumen and communication skills.
Assigned cases are to be worked individually and submitted before the start of class on the due date. No late cases will be accepted. Case must be typed and be of professional quality.
I am interested in the structured frameworks you use to solve the problem/s, assumptions made, analysis, recommendation and ability to clear communicate. Grading will consider:
• Critical Thinking: Have you formulated meaningful questions (what are the critical issues or problem), synthesized information and financial data, considered alternatives or improvements, proposed position / solutions.
• Analysis: Have you chosen the appropriate analytical framework/s to utilize and appropriately applied them. Assess quality of supporting evidence, key assumptions are identified and a clear recommendation supported by the analysis.
• Communication: The paper must be written clearly with a central message and logical organization. Ideas and recommendations are well supported. The case should contain an executive summary, framing of the problem, analysis, consideration of alternative solutions and recommendation. Please ensure correct spelling, grammar and clear formatting of financial exhibits. Use of tables and charts are often an efficient means to communicate financial information.
More information about each case will be provided approximately one week prior to the due date.
Papers should be between 3-5 pages in length plus any exhibits in an appendix.
This is a capital budgeting case. The goal is to gain practice applying project investment decisions. To become proficient, you must be able to: forecast all incremental cash flows related to the project, assess the reasonableness of the assumptions, estimate risk of the project and compute a the weighted average cost of capital, apply investment decision criteria to include: NPV, IRR, MIRR, Profitability Index and payback, interpret results and make a final recommendation.
To estimate the weighted average cost of capital you will need to:
• Utilize the Capital Asset Pricing Model to estimate the cost of equity:
o Risk Free Rate: The proxy for the Risk Free Rate should be a US Treasury note or bond with a duration of similar length as the asset being valued
o Beta: Find a company or set of companies that likely has a similar risk profile as the project. Use the company/s beta and make any required adjustments for financial leverage. Historical Betas can be found at a variety of finance sites to include: Yahoo! Finance, Google Finance and databases available at the PSU Library such as Standard & Poor’s.
o Market Risk Premium: Decide on an appropriate approach to estimate the Market Risk Premium and incorporate the necessary assumptions.
• Utilize the after tax yield to maturity of debt for the company or similar companies to estimate the cost of debt:
o A company will often have multiple bonds outstanding at any one time. If so, calculate a
weighted average YTM for the bonds outstanding.
o A list of bonds outstanding can be found in the company’s 10Q or 10K
o The current pricing and YTM on the bonds can be found at:
• Financing weights. Calculate the weights of debt and equity using book values and market values. Do they result in materially different weightings? For purposes of analyzing the project, please use the market value weights.
o The market value of equity is also known as market capitalization and can be determined by finding the current stock price per share and multiplying it by the number of shares outstanding.
o The market value of debt can be calculated from the bond site listed above.
o Market prices of bonds are often quoted as a percentage of par value. For example, if a bonds current price is 110, it is currently trading at 110% of par.
o The book values of debt and equity can be obtained from the company’s balance sheet