Sheetbend & Halyard Case

Jack Tar, CFO of Sheetbend & Halyard, Inc., opened the company’s confidential envelope. It contained a draft of a competitive bid for a contract to supply duffel canvas to the US Navy. The cover memo from the Sheetbend’s CEO asked Mr. Tar to review the bid before it was submitted.

The bid and its supporting documents had been prepared by Sheetbend’s sales staff. It called for Sheetbend to supply 100,000 yards of duffel canvas per year for five years. The proposed selling price was fixed at $30 per yard.

Mr. Tar was not usually involved in sales, but this bid was unusual in at least two respects. First, if accepted by the navy, the bid would commit Sheetbend to a fixed-price, long-term contract. Second, producing the duffel canvas would require and investment of $1.5 million to purchase machinery to refurbish Sheetbend’s plant in Pleasantboro, Maine.

Mr. Tar set to work and by the end of the week he had collected the following facts and assumptions:

The plant in Pleasantboro had been built in the early 1900s and is now idle. The plant was fully depreciated on Sheetbend’s books, except for the $10,000 purchase cost of the land (in 1947).

Because the land was valuable shorefront property, Mr. Tar thought the land and the idle plant could be sold, immediately or in the near future, for $600,000.

Refurbishing the plant would cost $500,000. This investment would be depreciated for tax purposes on the ten-year MACRS schedule.

The new machinery would cost $1 million. This investment could be depreciated on the five-year MACRS schedule.

The refurbished plant and new machinery would last for many years.; however, the remaining market for duffel canvas was small, and it was not clear that additional orders could be obtained once the navy contract was finished. The machinery was custom-built and could only be used for duffel canvas. Its second-hand value at the end of five years was probably zero.

Table 1-1 shows the sales staff’s forecast and decided that its assumptions were reasonable, except that the forecast used book, not tax, depreciation.

The forecast income statement contained no mention of working capital, but Mr. Tar thought that working capital would average about ten percent of sales.

Armed with this information, Mr. Tar constructed a spreadsheet to calculate the NPV of the duffel canvas project, assuming that Sheetbend’s bid would be accepted by the navy.

He had just finished debugging the spreadsheet when another confidential envelope arrived from Sheetbend’s CEO. It contained a firm offer from a Maine real estate developer to purchase Sheetbend’s Pleasantboro land and plant for $1.5 million in cash.

Should Mr. Tar recommend submitting the bid to the navy at the purposed price of $30 per yard? The discount rate for this project is twelve percent.

Table 1-1

Forecast income statement for the U.S. Navy duffel canvas project (dollar figures in thousands, except price per yard)

Notes:

Yards sold and price per yard would be fixed by contract

Cost of goods includes fixed cost of $300,000 per year plus variable costs of $18 per yard. Costs are expected to increase at the inflation rate of four percent per year.

Depreciation: A $1 million investment in machinery is depreciated straight-line over five years ($200,000 per year). The $500,000 cost of refurbishing the Pleasantboro plant is depreciated straight-line over ten years ($50,000 per year).

Please answer the following questions regarding the case study. Type your answers in the section of the course called “Case Study Two Questions.

Project the cash flows for the navy duffel canvas project for years 0 through 5.

Be sure to take into account the three main parts of a project valuation: initial costs, annual cash flows, and terminal value. As you do so, make the following assumptions (in addition to those already mentioned in the case):

The forecasts in Table 1-1 are accurate, except that depreciation should be calculated according to the MACRS schedules.

The $1.5 million offer for the land and plant represents the property’s true current market value (i.e., what it could be sold for) and the best estimate of its market value in 5 years.

For initial costs, remember to include cash flows for the cost of the land, plant, and machinery. The opportunity cost of the land should be included as part of your initial costs. (Note that if S&H opted to sell the land, there would be tax consequences associated with the sale.) Also remember to account for investment in working capital.

For terminal value, remember to include cash flows for selling or writing off the land, plant, and machinery at the conclusion of the project. (Don’t forget the tax consequences.) Also remember to account for the freeing up of working capital at the end of the project.

Note: Although you could do these projections with pencil, paper, and calculator, you should do this on an Excel spreadsheet. Attach the spreadsheet with your projections to your report.

What is the net present value of the navy duffel canvas project? What is the IRR of the project? Based on the assumptions that have been made, should S&H accept the project?

Perform some sensitivity analysis on your projections. Which assumptions concern you the most? Are there any reasonable changes in assumptions that would make you change your mind about whether or not to accept the project?

1 Project the cash flows for the navy duffel canvas project for years 0 through 5.

Be sure to take into account the three main parts of a project valuation: initial costs, annual cash flows, and terminal value. As you do so, make the following assumptions (in addition to those already mentioned in the case):

The forecasts in Table 8-6 are accurate, except that depreciation should be calculated according to the MACRS schedules.

The $1.5 million offer for the land and plant represents the property’s true current market value (i.e., what it could be sold for) and the best estimate of its market value in 5 years.

For initial costs, remember to include cash flows for the cost of the land, plant, and machinery. The opportunity cost of the land should be included as part of your initial costs. (Note that if S&H opted to sell the land, there would be tax consequences associated with the sale.) Also remember to account for investment in working capital.

For terminal value, remember to include cash flows for selling or writing off the land, plant, and machinery at the conclusion of the project. (Don’t forget the tax consequences.) Also remember to account for the freeing up of working capital at the end of the project.

Note: Although you could do these projections with pencil, paper, and calculator, you should do this on an Excel spreadsheet. Attach the spreadsheet with your projections to your report.

3. Perform some sensitivity analysis on your projections. Which assumptions concern you the most? Are there any reasonable changes in assumptions that would make you change your mind about whether or not to accept the project?