COURSE NAME:
EPPM3644 CORPORATE FINANCE
AND STRUCTURING
CASE STUDY 2:
CASE 24-CLEAR LAKE BAKERY
CAPITAL BUDGETING
LECTURER:
DR. AHMAD RAFLIS CHE OMAR
GROUP 3 MEMBERS:
AHMAD HUSAINI BIN SUPYAN GA04608
AHMAD ZUHDI B MOHD NOOR A172165
AHMAD SYAHIRUDIN RAHIMI A172150
NURSYAZWANI BINTI AB MAULLOD GA04641
DURGA A/P LETCHUMANAN GA04619
SYNOPSIS
Mike Ulig, a fourth-generation member of a family-owned bakery in Clear Lake, is thinking about
ways to automate more of his baking operation to both lodge the increasing demand for the cookies
but want to decrease the labour cost. It is difficult to find a labor in this resort community. In fact, it
is become more expensive.
Mike is a graduated in business major in college. He worked at the bakery since he was twelve years
old with the exception of about two years after college when he worked for a construction firm.
Mike is evaluating three projects: an automated mixer, a continuous baking oven, and a
semiautomated packing unit.
Clear Lake Bakery started in 1892 by a first-generation German family, Claus and Sonja Ulig who
wanted to serve a good quality bakery product in holiday season when tourists used to arrive during
winter season around the lake. Their major business was supply of usual bakery items and cookies
that they used to serve a town with population of 15,000 people and mostly outside the town
through mail orders. The company is considering the capital budgeting decision of purchasing three
equipment, viz. an automated mixer, a continuous baking oven and a semi-automated baking unit.
Even though the fresh bakery has stabilized over the past five years, Clear Lake Bakery has seen a
significant increase in demand for its cookies, most of which are sold by mail order. The baking
method is familiar to most people, and the way it is made at Clear Lake Bakery is not much different
from the way it is made at home. Only the scale is different. But Clear Lake Bakery uses a secret
recipe passed down from generation to generation.
The mail order business is due to the popularity of their sugar cookies, which have a long shelf life
and will stay fresh for almost a year. The cookie industry is well-suited to the massive surge in
demand for fresh baked goods that occurs with the influx of summer vacationers. High demand for
cookies occurs during the Easter, Thanksgiving, and Christmas seasons, which allows bakeries time
to build stock of cookies before demand peaks. For example, during the Christmas rush, up to four
UPS trucks per day will be filled with cookies. The company prides itself on dispatching any order
that arrives before 3 o’clock the same day. During off-season, any order arrives before 5pm. will be
shipped within the day. The bakery has about 100 full-time employees.
Clear Lake Bakery shares are traded over-the-counter and currently have a market price of $27 per
share. This year, the company paid a dividend of $1,215 per share. Earnings and dividends have
grown at a constant rate of 8% annually over the past ten years and are expected to continue to
grow at this rate for the foreseeable future. The company has one bond outstanding, a mortgage
bond with an 8% coupon, which pays semi-annual interest, with ten years to maturity. This bond is
currently selling at a discount and is listed at 871/2 ($875). The marginal tax rate for Clear Lake
Bakery is 35%.
Currently Clear Dakery has a wrapping machine which was purchased 4 years ago for and was being
depreciated on a seven-year MACRS schedule. The apper has a current market value of $20,000. The
packing unit will result in an operating expenses of $90,000 per year. These expenses are expected
to increase 5% per year, a seven-year wing unit will result wrapping machine Lake Bakery has a wrap
$90,000 and was being wrapper has a savings in operating exp percent per year over the ten-year
economic life of the unit.
QUESTION
1. Calculate the yield to maturity for the mortgage bond
PV= (875)
FV= 1000
PMT=40
N=10 N=20
Calc I/Y= 5.67 Semi annual
YTM = 11.34% YTM= 10%
2. Estimate CLB’s cost of equity
Cost of Equity= (Dividend next year/Stock price) + Dividend growth rate)
=(1.3122/27) +0.03
= 0.786 or 7.86%
= (1.125/27)+0.08
=12.5
= Dividend per share in future/market value per stock + dividend growth rate
3. What is the firms’ overall cost of capital?
Funding Type Funding Amount Cost% $ Cost
Shares 500,000 x 27 7.86% $ 1,061,100
=13,500,000
Mortgage Bond 5,143,000 11.34% $ 583,216.20
Totals 18,643,000 8.83% $ 1,644,316.20
4. Find the net cash flows for the automated mixer
3 Year Depreciation Model
Year Base % Depreciation Accumulated Final Book Value
Depreciation
1 $ 240,000 33.33 79,992 160,008
2 $ 240,000 44.45 186,672 53,328
3 $ 240,000 14.81 222,216 17,784
4 $ 240,000 7.41 240,000 0
Year 1 2 3 4 5 6 7
Increased $ 62,500.00 $ 65,625.00 $68, 906.25 $ 72,351.56 $ 75,969.14 $79,767.60 $ 83,755.98
Revenue
Decreased $ 22,500.00 $ 23,625.00 $ 24,806.25 $ 26,046.56 $27,348.89 $28,716.34 $30,152.15
Expenses
(Adds to
Cashflow)
Less: $ 79, 992.00 $ 106,680.00 $ 35,544.00 $ 17,784.00 $ 0.00 $0.00 $ 0.00
Depreciation
EBT $ 5,008.00 $17,430.00 $ 58,168.50 $ 80,614.13 $103,318.03 $ 108,483.99 $113,908.13
Less: Tax at $ 1,752.80 $ 6,100.50 $ 20,358.98 $28,214.94 $ 36,161.31 $ 37,969.38 $39,867.85
35%
Net Income $ 3,255.20 $11,329.50 $ 37,809.53 $52,399.18 $ 67,156.72 $70,514.56 $74,040.28
Add: $ 79,992.00 $ 106,680.00 $ 35,544.00 $ 17,784.00 $ 0.00 $ 0.00 $ 0.00
Depreciation
Net Cash $ 83,247.20 $95,350.50 $ 73,353.53 $ 70,183.18 $67,156.72 $70,514.56 $74,040.28
Flow
5. Calculate the NPV for the automated mixer
The discount rate as the overall cost of capital of 11.27%
Year Net Cash Flow PVIF @ 11.27% PV
0 (240,000.00) 1.00000 $(240,000.00)
1 83,247.20 0.89871 74,815.49
2 95,350.50 0.80769 77,013.49
3 73,353.53 0.72588 53,245.97
4 70,183.18 0.65236 45,784.73
5 67,156.72 0.58629 39,373.05
6 70,514.56 0.52690 37,154.40
7 74,040.28 0.47354 35,060.77
Net Present Value (NPV) $122,447.90
6. The internal rate of return for the mixer
Year Net Cash Flow
0 (240,000.00)
1 83,247.20
2 95,350.50
3 73,353.53
4 70,183.18
5 67,156.72
6 70,514.56
7 74,040.28
Internal Rate of Return (IRR) 26.73%
The Internal rate of Return (IRR) indicate the rate at which the NPV of any capital layout or
project will be zero. In other words, it is the rate at which any given capital project is expected
to grow annually at compounding rate. The overall cost of capital is 11.27% and the IRR is
26.73%, which means that the project is capable of earning more than the rate at which the
amount is invested in the asset.
7. The net present value of the continuous oven
Year Net Cash Flow PVIF @ 11.27% PV
0 (685,000) 1.00000 $(685,000)
1 102,510 0.89871 92,127.26
2 130,377 0.80769 105,303.99
3 117,178 0.72588 85,057.34
4 108,953 0.65236 71,076.63
5 104,368 0.58629 61,189.50
6 108,492 0.52690 57,164.87
7 112,871 0.47354 53,448.53
8 106,727 0.42557 45,420.26
9 100,836 0.38247 38,566.73
10 125,378 0.34373 43,096.35
Net Present Value (NPV) $(32,548.55)
8. The net present value of the semiautomated packing unit
0 1 2 3 4 5 6 7 8 9 10
Savings (Revenue) $90,000.00 $94,500.00 $99,225.00 $104,186.25 $109,395.56 $114,865.34 $120,608.61 $126,639.04 $132,970.99 $139,619.54
Less:
$(55,731.00) $(95,511.00) $(68,211.00) $(48,711.00) $(34,827.00) $(34,788.00) $(34,827.00) $(17,394.00) $ - $ -
Decpreciation
Old Machine
4 5 6 7
Decpriciation
$8,037.00 $8,028.00 $8,037.00 $4,014.00
TOTAL DEP $(47,694.00) $(87,483.00) $(60,174.00) $(44,697.00) $(34,827.00) $(34,788.00) $(34,827.00) $(17,394.00) $ - $ -
BV $28,116.00
Selling Price 20,000.00
$28,116.00
TAX $2,840.60
EBT $34,269.00 $(1,011.00) $31,014.00 $55,475.25 $74,568.56 $80,077.34 $85,781.61 $109,245.04 $132,970.99 $139,619.54
TAX $11,994.15 $(353.85) $10,854.90 $19,416.34 $26,099.00 $28,027.07 $30,023.56 $38,235.76 $46,539.85 $48,866.84
Old Machine Tax
$(2,840.60)
Benefit:
Net Income $25,115.45 $(657.15) $20,159.10 $36,058.91 $48,469.57 $55,758.04 $55,758.04 $71,009.27 $86,431.14 $90,752.70
Add Depreciation $55,731.00 $95,511.00 $68,211.00 $48,711.00 $34,827.00 $34,827.00 $34,827.00 $17,394.00 $ - $ -
Cashflows $80,846.45 $94,853.85 $88,370.10 $84,769.91 $83,296.57 $90,585.04 $90,585.04 $88,403.27 $86,431.14 $90,752.70
NPV $7,123.80
9. Which capital projects should Mike undertake this year?
The projects Mike should undertake are the automated mixer because the NPV is positive
and this project will add value to the firm. The Baking oven should not be undertaken because
the NPV indicates a negative value to the firm. Thus, making it a bad business decision to go
through with it. The semi-automated packing unit should be taken because it has a positive
NPV, which indicated added value to the firm. Due to our capital of $1,000,000 we should
take both the automated mixer and semi-automated packing unit.
