This case study on capital investment analysis can be applied to introductory courses in finance, financial decision making, and corporate finance.

  International Research Journal of Applied Fin" rel="nofollow">inance ISSN 2229 – Vol. VII Issue – 8 August, 2016 Case Study Series Page 1 Capital Investment Analysis: Roman Manufacturin" rel="nofollow">ing Company Case Study Arthur S. Guarin" rel="nofollow">ino Abstract This case study on capital in" rel="nofollow">investment analysis can be applied to in" rel="nofollow">introductory courses in" rel="nofollow">in fin" rel="nofollow">inance, fin" rel="nofollow">inancial decision makin" rel="nofollow">ing, and corporate fin" rel="nofollow">inance. Three alternative capital in" rel="nofollow">investment projects are available for evaluation. The in" rel="nofollow">investment options must be carefully examin" rel="nofollow">ined and a decision arrived at based on a fin" rel="nofollow">inancial analysis of the in" rel="nofollow">information provided in" rel="nofollow">in the case usin" rel="nofollow">ing capital budgetin" rel="nofollow">ing and capital structure techniques. Keywords: Capital asset pricin" rel="nofollow">ing model (cost of equity), Internal Rate of Return, Net Present Value, Payback Period, Yield to Maturity (cost of debt), Weighted Average Cost of Capital Introduction Stefano Romano is the Chief Executive Officer of Roman Manufacturin" rel="nofollow">ing Company, a shoe manufacturin" rel="nofollow">ing firm located in" rel="nofollow">in New York City, and he is lookin" rel="nofollow">ing to expand the company’s product lin" rel="nofollow">ine. The company has manufactured shoes for workin" rel="nofollow">ing class and middle class families and a luxury brand footwear that has been highly profitable. Stefano wishes to diversify the company’s product lin" rel="nofollow">ine in" rel="nofollow">into casual footwear or athletic shoes. Based upon marketin" rel="nofollow">ing studies commissioned by Roman Manufacturin" rel="nofollow">ing, the company’s profits, based on the product diversification, could in" rel="nofollow">increase 15 to 20% in" rel="nofollow">in the next ten years. However, Stefano has been in" rel="nofollow">introduced to another busin" rel="nofollow">iness venture that could expand the luxury brand footwear lin" rel="nofollow">ine through an acquisition of a well-known Italian designer house known as House of Napoli Shoes that would give Roman Manufacturin" rel="nofollow">ing a larger share of the global market in" rel="nofollow">in high end shoes. Stefano needs to decide which of the three areas Roman Manufacturin" rel="nofollow">ing should focus on and make an in" rel="nofollow">investment. Company Background Roman Manufacturin" rel="nofollow">ing Company is a shoe manufacturin" rel="nofollow">ing company located in" rel="nofollow">in New York City and has been in" rel="nofollow">in busin" rel="nofollow">iness sin" rel="nofollow">ince 1900. Giuseppe Romano came to the United States as a young boy and was immediately apprenticed as a shoe maker in" rel="nofollow">in New York City. Giuseppe not only had a knack for makin" rel="nofollow">ing and repairin" rel="nofollow">ing shoes but a sense of style and busin" rel="nofollow">iness that allowed him to open his first shoe repair store at age twenty. His schoolin" rel="nofollow">ing was quite limited, but he was a whiz at numbers, and recognizin" rel="nofollow">ing a good busin" rel="nofollow">iness deal when he saw one. He was also a people person and got along well with his customers allowin" rel="nofollow">ing him plenty of repeat busin" rel="nofollow">iness. Many of his customers were fin" rel="nofollow">inancial people, who were in" rel="nofollow">involved in" rel="nofollow">in commercial bankin" rel="nofollow">ing, in" rel="nofollow">investments, fin" rel="nofollow">inance, and stock brokerage. Giuseppe repaired and shin" rel="nofollow">ined their shoes but also asked questions that lead him to read the Wall Street Journal and in" rel="nofollow">invest in" rel="nofollow">in the stock market. As his busin" rel="nofollow">iness grew so did his shoe repair stores in" rel="nofollow">in New York City and his in" rel="nofollow">interest in" rel="nofollow">in manufacturin" rel="nofollow">ing shoes. He started his first shoe manufacturin" rel="nofollow">ing plant in" rel="nofollow">in Brooklyn by buyin" rel="nofollow">ing up a bankrupt busin" rel="nofollow">iness durin" rel="nofollow">ing the height of the Great Depression and expandin" rel="nofollow">ing when many others were closin" rel="nofollow">ing down. Giuseppe renamed the busin" rel="nofollow">iness, Roman Manufacturin" rel="nofollow">ing Company, which at first made shoes for the middle class consumer. This in" rel="nofollow">involved shoes that people wore every day and would last. If the consumer needed to have the shoe repaired, it could be brought to any of Giuseppe’s shoe repair stores, at a low or no cost. Eventually, Giuseppe expanded the company’s product lin" rel="nofollow">ine to highly fashionable shoes which meant hirin" rel="nofollow">ing designers and craftsman from Italy. Helped by favorable reviews from fashion magazin" rel="nofollow">ines and endorsements from movie, television, and Broadway celebrities, this lin" rel="nofollow">ine of the busin" rel="nofollow">iness eventually brought in" rel="nofollow">in over 50% of the company’s revenue. The profits for the fashionable shoes lin" rel="nofollow">ine were phenomenal and 100% were rein" rel="nofollow">invested in" rel="nofollow">into Roman Manufacturin" rel="nofollow">ing. International Research Journal of Applied Fin" rel="nofollow">inance ISSN 2229 – 6891 Vol. VII Issue – 8 August, 2016 Case Study Series Page 2 His five children became in" rel="nofollow">interested in" rel="nofollow">in different facets of the busin" rel="nofollow">iness and eventually Roman Manufacturin" rel="nofollow">ing Company was able to expand to the entire East Coast of the United States and across to the Mississippi River. The next generation (Giuseppe’s grandchildren) became in" rel="nofollow">involved in" rel="nofollow">in the busin" rel="nofollow">iness and was lookin" rel="nofollow">ing to expand in" rel="nofollow">into different types of footwear, possibly athletic shoes or casual footwear. The factor that would set them apart from other manufacturers was that Roman Manufacturin" rel="nofollow">ing would make their product in" rel="nofollow">in the United States, in" rel="nofollow">in New York City, while others companies were goin" rel="nofollow">ing overseas due to lower costs and bigger profits. Current Situation Stefano, Giuseppe’s third grandchild, was now runnin" rel="nofollow">ing Roman Manufacturin" rel="nofollow">ing, while his cousin" rel="nofollow">in, Guido, was director of manufacturin" rel="nofollow">ing operations. Guido presented to Stefano and the other managers his research in" rel="nofollow">into the costs of acquirin" rel="nofollow">ing new machin" rel="nofollow">inery for the athletic footwear and casual shoes lin" rel="nofollow">ines. However, Lorenzo brought forth the possibility of settin" rel="nofollow">ing up a subsidiary in" rel="nofollow">in Southern Italy makin" rel="nofollow">ing a new lin" rel="nofollow">ine of men’s and women’s luxury shoes. Establishin" rel="nofollow">ing a new manufacturin" rel="nofollow">ing branch in" rel="nofollow">in Southern Italy caught Stefano totally off-guard, but when Lorenzo, another cousin" rel="nofollow">in and the company’s chief fin" rel="nofollow">inancial officer, heard that a long-established Italian family was lookin" rel="nofollow">ing to sell their company, House of Napoli Shoes, at a fairly reasonable price, the opportunity presented Stefano with an in" rel="nofollow">intriguin" rel="nofollow">ing possibility he could not ignore. Stefano and Guido had come to the conclusion that Roman’s manufacturin" rel="nofollow">ing plant needed ten new machin" rel="nofollow">ines to make athletic shoes. The cost would be $1.25 million dollars just for the new machin" rel="nofollow">inery imported from abroad. Materials and supplies as well as worker’s salaries and benefits would come to be $1 million. The total cost would be $2.25 million. Roman Manufacturin" rel="nofollow">ing had the floor-space for the machin" rel="nofollow">ines and could transition to the new product lin" rel="nofollow">ine in" rel="nofollow">in approximately six months. Guido also did research in" rel="nofollow">into the machin" rel="nofollow">inery needed for the casual footwear lin" rel="nofollow">ine. Roman would need ten new machin" rel="nofollow">ines, imported from overseas, at a cost of $2 million. The cost of materials and supplies and worker’s wages would be $1.25 million for a total cost of $3.25 million. These machin" rel="nofollow">ines would need less floor space than the machin" rel="nofollow">ines for the athletic footwear and would take approximately four months to start manufacturin" rel="nofollow">ing operations. The situation with the purchase of the Italian shoe manufacturin" rel="nofollow">ing company, House of Napoli Shoes, was more complicated. First, the sale would have to be approved by the Italian government and the anti-trust division of the European Union (EU). Once that hurdle was cleared then the unions in" rel="nofollow">involved with the company would have to be assured that no jobs would be lost after the sale took place. Stefano knew that the situation regardin" rel="nofollow">ing the relationship with the unions could hurt Roman’s reputation in" rel="nofollow">in Italy and the United States if it was not handled correctly. Stefano always felt that bad publicity will hurt a good company every time. Guido and Lorenzo had been in" rel="nofollow">in negotiations with the Italian firm as well as with the anti-trust division of the EU and the unions. Guido and Lorenzo were able to work out a deal in" rel="nofollow">in which Roman would purchase the Italian firm for $500 million. The deal would be all cash and fin" rel="nofollow">inanced by the sale of corporate bonds and common and preferred stock to new and existin" rel="nofollow">ing shareholders. Fin" rel="nofollow">inancial Information Stefano, after consultin" rel="nofollow">ing with Guido and Lorenzo as well as with Roman’s accountin" rel="nofollow">ing firm, in" rel="nofollow">investment bankers, and fin" rel="nofollow">inancial advisors came up with three different methods to fin" rel="nofollow">inance each possible venture. International Research Journal of Applied Fin" rel="nofollow">inance ISSN 2229 – 6891 Vol. VII Issue – 8 August, 2016 Case Study Series Page 3 For the casual footwear lin" rel="nofollow">ine, the commercial bank Roman Manufacturin" rel="nofollow">ing has been workin" rel="nofollow">ing with sin" rel="nofollow">ince the busin" rel="nofollow">iness was purchased by Giuseppe in" rel="nofollow">in 1933 could make a loan for $3.25 million at a fixed rate of 5% for a term of 10 years with monthly loan payments of $17,447.90. However, there was a prepayment penalty of 2% of the remain" rel="nofollow">inin" rel="nofollow">ing balance of the loan if it were paid off in" rel="nofollow">in the first five years. For fin" rel="nofollow">inancin" rel="nofollow">ing the athletic shoes lin" rel="nofollow">ine, Stefano, based upon Lorenzo’s recommendation, was considerin" rel="nofollow">ing usin" rel="nofollow">ing a fin" rel="nofollow">inance company from Chicago. The loan would be for $2.25 million for 10 years at a rate of 6.5% without any prepayment penalties and at a monthly payment of $14,222.43. The fin" rel="nofollow">inancin" rel="nofollow">ing for the purchase of the Italian footwear company would be the costliest, more complicated, and, Stefano felt, have the highest amount of risk. The fin" rel="nofollow">inancin" rel="nofollow">ing would be done usin" rel="nofollow">ing a split of corporate bonds, preferred stock, and issuin" rel="nofollow">ing a new class of common stock specifically designated for the purchase. Fifty percent of the $500 million purchase would be usin" rel="nofollow">ing callable bonds with a coupon in" rel="nofollow">interest rate of 5% at a par value of $1,000 per bond and a term of 30 years. The 250,000 issued bonds would pay in" rel="nofollow">interest semi-annually and, with Roman’s corporate tax rate at 34%, the after-tax in" rel="nofollow">interest rate on the issue would be 3.3%. The would have a market price of 103 as a percentage of par. Twenty-five percent of the purchase price would be fin" rel="nofollow">inanced usin" rel="nofollow">ing non-cumulative preferred stock issued with a par value of $100 per share and payin" rel="nofollow">ing dividends quarterly at a rate of 10%. The cost of capital for the preferred stock issue would be 7%. The other 25% of the cash to be raised would come from the sale of a new class of common stock at a projected price of $25.00 per share, not payin" rel="nofollow">ing dividends for the first five years of the issue, no votin" rel="nofollow">ing rights, and 5 million shares authorized to be issued. The in" rel="nofollow">investment bankers hired by Roman Manufacturin" rel="nofollow">ing have projected that its β would be 1.25, higher than Stefano and Lorenzo wanted it to be. Also, T-bills are currently at a rate of 3%, while the market return rate is 9%. Another piece of the puzzle, and perhaps the most important, are the cash flows each venture could potentially brin" rel="nofollow">ing to Roman Manufacturin" rel="nofollow">ing, assumin" rel="nofollow">ing a 10% discount rate. Lorenzo’s staff has come up with the followin" rel="nofollow">ing projected cash flows: Year Casual Shoes Athletic Shoes House of Napoli Shoes 1 −$500,000 $850,000 $1,000,000 2 −$400,000 $850,000 $1,500,000 3 $300,000 $850,000 $2,000,000 4 $500,000 $850,000 $2,500,000 5 $800,000 $850,000 $3,500,000 6 $900,000 $850,000 $4,500,000 7 $1,250,000 $850,000 $5,000,000 8 $1,500,000 $850,000 $5,500,000 9 $1,750,000 $850,000 $6,000,000 10 $2,000,000 $850,000 $6,500,000 International Research Journal of Applied Fin" rel="nofollow">inance ISSN 2229 – 6891 Vol. VII Issue – 8 August, 2016 Case Study Series Page 4 While Roman Manufacturin" rel="nofollow">ing is largely a family-owned company, with the Romano family controllin" rel="nofollow">ing 51% of the firm’s votin" rel="nofollow">ing stock, Stefano knew he would have to present management’s fin" rel="nofollow">inal decision to the board of directors. For Stefano, there were still questions and concerns that needed to be addressed which he listed in" rel="nofollow">in a memo to Lorenzo and requested an answer in" rel="nofollow">in one week. Roman Manufacturin" rel="nofollow">ing Company Makin" rel="nofollow">ing Great Shoes sin" rel="nofollow">ince 1933 To: Lorenzo Romano – CFO From: Stefano Romano – CEO Date: July 2, 2016 Re: Questions regardin" rel="nofollow">ing ventures under consideration I have been thin" rel="nofollow">inkin" rel="nofollow">ing about the proposed acquisition of House of Napoli Shoes and the manufacturin" rel="nofollow">ing equipment and ancillary items regardin" rel="nofollow">ing the athletic shoes and casual footwear ventures. I have certain" rel="nofollow">in questions regardin" rel="nofollow">ing fin" rel="nofollow">inancial matters of each project. I have listed the questions below and would like a detailed reply in" rel="nofollow">in one week in" rel="nofollow">in a memo and a follow-up meetin" rel="nofollow">ing. 1. What is the net present value (NPV) for each venture? And based on the prin" rel="nofollow">inciple of mutually exclusivity, which venture(s) should be accepted or rejected? 2. What is the in" rel="nofollow">internal rate of return (IRR) for each venture? Given that the company’s cost of capital is 10%, which venture(s) should be accepted or rejected? 3. What are the Payback Periods for each venture? Which venture(s) should we accept given the company’s cutoff period of three (3) years? 4. By usin" rel="nofollow">ing the Capital Asset Pricin" rel="nofollow">ing Model (CAPM), fin" rel="nofollow">ind the required return on equity for the purchase of House of Napoli Shoes. 5. Examin" rel="nofollow">ine the proposed bond issue to be used in" rel="nofollow">in the acquisition of House of Napoli Shoes and fin" rel="nofollow">ind its cost of debt usin" rel="nofollow">ing the yield to maturity. 6. Given the weights of the equity portion (both preferred and common stock) and debt in" rel="nofollow">in the capital structure for the House of Napoli Shoes venture let me know what is Roman’s weighted average cost of capital in" rel="nofollow">involvin" rel="nofollow">ing the deal. 7. What do you thin" rel="nofollow">ink are the best fin" rel="nofollow">inancial decision rules that should be used in" rel="nofollow">in order to make a correct decision for the three possible ventures? 8. Are there any key questions that should be considered? 9. As CFO, which of the three ventures do you thin" rel="nofollow">ink Roman Manufacturin" rel="nofollow">ing should pursue and why? Author Arthur S. Guarin" rel="nofollow">ino Assistant Professor, Department of Fin" rel="nofollow">inance and Economics, Rutgers University, USA, arthur.guarin" rel="nofollow">in[email protected]