Harris Seafoods, Inc.

Processing Plant Proposal

Valuing the processing plant proposal:
Harris is considering building a processing plant for $7.0M

What do you think of this plan?

To do’s:

• Calculate discount rate, WACC

• Forecast free cash flows
• Compute NPV

2
Valuing the processing plant proposal:
Weighted Average Cost of Capital (WACC):
→ Discount the FCF using the weighted average of after-tax
debt costs and equity costs

D E
WACC = k D (1 − t ) + kE
D+E D+E

3
The required inputs:
• WACC inputs:
→ Determine the relevant target capital structure for the project.
→ Determine the required return on equity.
→ Determine the required return on debt
debt.
→ Determine the marginal tax rate.

4
Target
g Capital
p Structure D/(D+E)
( )
Theory:

5
Target
g Capital
p Structure D/(D+E)
( )
Theory: We need the target capital structure D/(D+E) in market
values of the processing plant as a stand-alone.

6
Target
g Capital
p Structure D/(D+E)
( )
Theory: We need the target capital structure D/(D+E) in market
values of the processing plant as a stand-alone.

How do we get an estimate?

7
Target
g Capital
p Structure D/(D+E)
( )
Theory: We need the target capital structure D/(D+E) in market
values of the processing plant as a stand-alone.

How do we get an estimate?

→ Look at comparables (e.g.
(e g other processed shrimp comps)
comps).
→ Ask “what does Harris think is optimal for the new business”
→ Need to check that these capital structures are “reasonable”
using the checklist and common sense
sense.

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Target
g Capital
p Structure D/(D+E)
( )
Theory: We need the target capital structure D/(D+E) in market
values of the processing plant as a stand-alone.

How do we get an estimate?

→ Look at comparables (e.g.
(e g other processed shrimp comps)
comps).
→ Ask “what does Harris think is optimal for the new business”
→ Need to check that these capital structures are “reasonable”
using the checklist and common sense
sense.

Questions:
1) More or less in the same industry – OK to use same debt ratio?
2) Is it generally ok to use parent’s debt ratio for project’s capital
structure?

9
Target
g Capital
p Structure (cont.)
( )
Looking at comparables in the processed shrimp industry

Î Values are taken from Exhibits 4 and 5, year 1979

Î Book debt = Notes payable + Long-term debt + Current maturities of long-
t
term debt
d bt

Therefore, relevant capital structure for Harris’s new plant is the average of
these two comparables: D/(D+E) = 40%

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C t off D
Cost bt kD
Debt
Theory:

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C t off D
Cost bt kD
Debt
Theory: The expected return that creditors would demand:
• if the shrimp processing plant was a stand-alone firm.
• and had a 40% market leverage ratio.

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C t off D
Cost bt kD
Debt
Theory: The expected return that creditors would demand:
• if the shrimp processing plant was a stand-alone firm.
• and had a 40% market leverage ratio.

How do we get it?

13
C t off D
Cost bt kD
Debt
Theory: The expected return that creditors would demand:
• if the shrimp processing plant was a stand-alone firm.
• and had a 40% market leverage ratio.

How do we get it?

• 40% leverage is low enough to assume kD= interest rate

• Hence we need to find the interest rate that Harris expects to be

charged on its newly issued long-term debt.

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C t off D
Cost bt kD
Debt
Theory: The expected return that creditors would demand:
• if the shrimp processing plant was a stand-alone firm.
• and had a 40% market leverage ratio.

How do we get it?

• 40% leverage is low enough to assume kD= interest rate

• Hence we need to find the interest rate that Harris expects to be

charged on its newly issued long-term debt.

• According to the case, Harris expects kD = 13.5%

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Marginal Tax Rate t
Theory:

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Marginal Tax Rate t
Theory: The marginal tax rate of the combined entity, Harris plus
its new shrimp processing plant
→ Why Harris? Because the tax savings are determined by the
marginal tax rate of the combined firm.
→ The pprocessing gpplant as a standalone might
g have a higherg
probability of losses. Harris will almost certainly pay taxes –
even if the new plant loses some money.

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Marginal Tax Rate t
Theory: The marginal tax rate of the combined entity, Harris plus
its new shrimp processing plant
→ Why Harris? Because the tax savings are determined by the
marginal tax rate of the combined firm.
→ The pprocessing gpplant as a standalone might
g have a higherg
probability of losses. Harris will almost certainly pay taxes –
even if the new plant loses some money.

What is it?

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Marginal Tax Rate t
Theory: The marginal tax rate of the combined entity, Harris plus
its new shrimp processing plant
→ Why Harris? Because the tax savings are determined by the
marginal tax rate of the combined firm.
→ The pprocessing gpplant as a standalone might
g have a higherg
probability of losses. Harris will almost certainly pay taxes –
even if the new plant loses some money.

What is it?
→ From case page 5: t = 48%

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Cost of Equity kE
• Approach:

1. Find comparable companies.

2. Estimate equity betas of comparable companies.

3. Unlever each of the equity betas to get asset betas.

4. Calculate the average asset beta.

5. Relever the average asset beta to estimate equity beta for

Collinsville, using the target capital structure.

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Cost of Equity kE
STEP 1: Find firms comparable to the new processing plant

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Cost of Equity kE
STEP 1: Find firms comparable to the new processing plant

→ Pure plays in processed shrimp: Treasure Isle & Ocean

Foods

→ These firms should have a business risk comparable (to

each other and) to Harris’s new plant.

Remarks:
• For kE, need really close comps (moreso than for D/V and kD):
Same business but also, if possible, same size, etc.

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Estimating kE (cont.):
(cont ):
STEP 2: Unlever each comp’s βE to estimate its βA

⎛ E ⎞ ⎛ D ⎞
β A = βE ⎜ ⎟ + βD ⎜ ⎟
⎝ E + D ⎠ ⎝ E + D ⎠

Î Gives an estimate of βA for processed shrimp business.

Book Shares Share Market D/ βΕ βD βΑ

Debt Out Price Equity (D+E)

Treasure Isle 6,784 507 10.88 5,516 55% 1.62 0.00 0.73
Ocean Foods 3,102 881 11.25 9,911 24% 0.86 0.00 0.65

Î The βA’s are somewhat similar, so we can take an average βA: 0.69

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Estimating kE (cont.):
(cont ):

Big Mistake: Averaging the βE instead of the βA. Why?

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Estimating kE (cont.):
(cont ):

Big Mistake: Averaging the βE instead of the βA. Why?

What’s Next?

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Estimating kE (cont.)
STEP 3: Relever the βA to estimate the new processing plant’s βE:
→ Assuming a debt beta of 0.0:
⎛ E ⎞ ⎛ D ⎞
β A = βE ⎜ +
⎟ D⎜β ⎟
⎝E + D⎠ ⎝E + D⎠
0.69 = β E ( 0.60 )
β E = 1.15

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Estimating kE (cont.)
STEP 3: Relever the βA to estimate the new processing plant’s βE:
→ Assuming a debt beta of 0.0:
⎛ E ⎞ ⎛ D ⎞
β A = βE ⎜ +
⎟ D⎜β ⎟
⎝E + D⎠ ⎝E + D⎠
0.69 = β E ( 0.60 )
β E = 1.15
→ Use CAPM to estimate kE: kE = rf + βE * (rm- rf).

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Estimating kE (cont.)
STEP 3: Relever the βA to estimate the new processing plant’s βE:
→ Assuming a debt beta of 0.0:
⎛ E ⎞ ⎛ D ⎞
β A = βE ⎜ +
⎟ D⎜β ⎟
⎝E + D⎠ ⎝E + D⎠
0.69 = β E ( 0.60 )
β E = 1.15
→ Use CAPM to estimate kE: kE = rf + βE * (rm- rf). What’s rf?

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Estimating kE (cont.)
STEP 3: Relever the βA to estimate the new processing plant’s βE:
→ Assuming a debt beta of 0.0:
⎛ E ⎞ ⎛ D ⎞
β A = βE ⎜ +
⎟ D⎜β ⎟
⎝E + D⎠ ⎝E + D⎠
0.69 = β E ( 0.60 )
β E = 1.15
→ Use CAPM to estimate kE: kE = rf + βE * (rm- rf). What’s rf?
rm - rf
D/(E+D) E/(E+D) βΕ rf (historical) kE
40% 60% 1.15 12.4% 7.0% 20.5%

Risk free rate from Exhibit 7, 1980 long-term government bond rate
Market risk premium from historical average

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 Estimating kE (cont.)
STEP 3: Relever the βA to estimate the new processing plant’s βE:
→ Assuming a debt beta of 0.0:
⎛ E ⎞ ⎛ D ⎞
β A = βE ⎜ +
⎟ D⎜β ⎟
⎝E + D⎠ ⎝E + D⎠
0.69 = β E ( 0.60 )
β E = 1.15
→ Use CAPM to estimate kE: kE = rf + βE * (rm- rf). What’s rf?
rm - rf
D/(E+D) E/(E+D) βΕ rf (historical) kE
40% 60% 1.15 12.4% 7.0% 20.5%
Robustness check
30% 70% 0.99 12.4% 7.0% 19.3%
40% 60% 1.15 12.4% 7.0% 20.5%
50% 50% 1 38
1.38 12 4%
12.4% 7 0%
7.0% 22 1%
22.1%
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 Pulling
g It All Together
g
D E
WACC = k D (1− t ) + kE
D+E D+E
D/(E+D) kD (1-t) E/(E+D) kE WACC
40% 13.50% 52% 60% 20.5% 15.1%
Robustness check
30% 13.50% 52% 70% 19.3% 15.6%
40% 13.50% 52% 60% 20.5% 15.1%
50% 13 50%
13.50% 52% 50% 22 1%
22.1% 14 5%
14.5%

Î Bottom line: Look at WACC between 14% and 16%

Note: WACC declines with leverage not because kD < kE but because of the
tax shield of debt (Caveat: This ignores costs of distress).

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FCF: Assumptions
p

• 1980-86: Use numbers from Exhibit 7, assuming 11% inflation.

• 1986 Terminal
1986: T i l value:
l
→ Assume that 1986 FCF grows at a constant rate indefinitely.
→ In this case, assume the growth rate equals 11% inflation.

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 Valuation of New Processing Plant
1980 1981 1982 1983 1984 1985 1986
EBIT - (363) 4,139 7,119 8,141 9,287 10,564
Taxes at 48% - (174) 1,987 3,417 3,908 4,458 5,071
EBIT (1-t) - (189) 2,152 3,702 4,233 4,829 5,493
Depreciation - 833 787 758 746 748 764
PPE 7,000 6,944 7,019 7,218 7,535 7,966 8,511
Other long-term assets 100 435 1,056 1,390 1,568 1,771 1,999
Δ(PPE+Other) 279 696 533 495 634 773
CAPX 7,100 1,112 1,483 1,291 1,241 1,382 1,537
Cash 450 290 704 927 1,046 1,181 1,333
Accounts receivable - 2,416 5,862 7,719 8,710 9,834 11,101
Inventories 2,485 5,063 9,810 12,918 14,575 16,457 18,577
Other current assets - 580 1,408 1,853 2,091 2,361 2,665
Current liabilities (9% sales per case) - 2,610 6,334 8,340 9,410 10,625 11,994
NWC=Cash + A/R + Inv + Other - A/P 2,935 5,739 11,450 15,077 17,012 19,208 21,682
ΔNWC 2,935 2,804 5,711 3,627 1,935 2,196 2,474
Investment tax credit per case 650

Free Cash Flow (10,035) (2,622) (4,255) (458) 1,803 1,999 2,246

Terminal value (end 1986)

Growth rate, g 11.0%
FCF in 1986 2,246
FCF in
i 1987 = FCF1986 * (1+g)
(1 ) 2 493
2,493
Perp Value = FCF1987 / (WACC-g) 54,197

PV at 1980 1980-86 Terminal NPV

Discount rate, WACC 15.1% PV (12,842) 23,309 10,467

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Robustness Check on WACC
PV at 1980 1980-86 Terminal NPV
Discount rate 14.0% PV (12,788) 24,691 11,903
Discount rate 14.5% PV (12,813) 24,051 11,238
Discount rate 15.1% PV (12,842) 23,309 10,467
Discount rate 15.5% PV (12,859) 22,829 9,969
Discount rate 16.0% PV (12,881) 22,245 9,364

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Sensitivity
y to change
g in terminal g
growth rate

• 1980-86: Use numbers from Exhibit 7, assuming 11% inflation.

• 1986 Terminal
1986: T i l value:
l
→ Change terminal growth rate to 3.0%

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 Valuation of New Processing Plant
1980 1981 1982 1983 1984 1985 1986
EBIT - (363) 4,139 7,119 8,141 9,287 10,564
Taxes at 48% - (174) 1,987 3,417 3,908 4,458 5,071
EBIT (1-t) - (189) 2,152 3,702 4,233 4,829 5,493
Depreciation - 833 787 758 746 748 764
PPE 7,000 6,944 7,019 7,218 7,535 7,966 8,511
Other long-term assets 100 435 1,056 1,390 1,568 1,771 1,999
Δ(PPE+Other) 279 696 533 495 634 773
CAPX 7,100 1,112 1,483 1,291 1,241 1,382 1,537
Cash 450 290 704 927 1,046 1,181 1,333
Accounts receivable - 2,416 5,862 7,719 8,710 9,834 11,101
Inventories 2,485 5,063 9,810 12,918 14,575 16,457 18,577
Other current assets - 580 1,408 1,853 2,091 2,361 2,665
Current liabilities (9% sales per case) - 2,610 6,334 8,340 9,410 10,625 11,994
NWC=Cash + A/R + Inv + Other - A/P 2,935 5,739 11,450 15,077 17,012 19,208 21,682
ΔNWC 2,935 2,804 5,711 3,627 1,935 2,196 2,474
Investment tax credit per case 650

Free Cash Flow (10,035) (2,622) (4,255) (458) 1,803 1,999 2,246

Terminal value (end 1986)

Growth rate, g 3.0%
FCF in 1986 2,246
FCF in
i 1987 = FCF1986 * (1+g)
(1 ) 2 313
2,313
Perp Value = FCF1987 / (WACC-g) 18,360

PV at 1980 1980-86 Terminal NPV

Discount rate, WACC 15.1% PV (12,842) 7,896 (4,945)

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Breakeven terminal growth rate check
• PV from years 1980 to 1986 = - $12,842k
• PV off tterminal
i l value
l = CF1987 2, 313k
=
WACC − g .151− g

• S i these
Setting h two equall to each
h other
h yields
i ld g = 7.4%
4%

37
Takeaways from Harris:
• Discounted cash flow valuations, applied mechanically, do not
give “the
the correct answer”
answer .

• Rather, DCF is a useful tool for translating information about

project
j t economics
i iinto
t a statement
t t t about
b t value
l creation.
ti

• DCF plus sensitivity analysis: a good way to identify key “value

drivers” - those factors that merit most careful thought.

• y driven by
DCF is entirely y the assumptions.
p
→ We need to test how sensitive our answers are to changes in
the assumptions.

38
Remark 1: Why not use 100% debt for this
project because of Industrial Revenue Bond
option?
ti ?

39
Remark 1: Why not use 100% debt for this
project because of Industrial Revenue Bond
option?
ti ?
• Harris does not need to launch a processed shrimp business to
l
lever up.
→ It could simply do a leveraged recap

• Additionally, in the long-run, this would not be a sustainable

business model for this new business.

40