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Capital Budgeting with Staged Entry 16A GULF COAST FISHERIES, INC. Directed The senior executives of Gulf Coast Fisheries, Inc. (GCF), a leading...

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Capital Budgeting with Staged Entry 16A GULF COAST FISHERIES, INC. Directed The senior executives of Gulf Coast Fisheries, Inc. (GCF), a leading seafood harvester and proces- sor, scheduled a meeting in early 1995 to consider a significant change in corporate strategy. Gulf Coast’s present strategy is to concentrate solely on harvesting and processing seafood from the Atlantic Ocean and the Gulf of Mexico. The company’s products include a variety of saltwater fish, crab, lobster, shrimp, oysters, scallops, and clams. However, increased competition from low- cost foreign producers has hurt profits, and overharvesting and pollution have decreased the fish and shellfish population, resulting in significantly lower yields. Furthermore, the government frequently bans oyster harvesting along much of the Atlantic and Gulf coasts, following cases where people became sick after eating contaminated oysters. These factors prompted GCF to reconsider its basic strategic plan, and management is now thinking of making a major move into the freshwater cat- fish market. GCF was founded in 1960 in New Orleans by a consortium of commercial fishermen whose plan was to provide Americans throughout the country with fresh seafood. GCF’s sales in 1994 were $65 million, and its net income was $1.5 million. The company’s seafood is regarded as being of the highest quality, and the firm has the reputation of being a leader in its chosen line. Still, for the reasons cited above, the profit trend has been down in recent years, and unless there are fundamen- tal changes, losses will eventually occur. All prior proposals to enter the catfish market were rejected because (1) Gulf Coast’s operat- ing and marketing advantages have always been in seafood (saltwater products), and (2) since con- sumer demand for catfish was primarily limited to only a few areas in the Deep South, management did not regard the catfish market as having enough profit potential to make the investment worth- while. Recently, though, consumer demand for catfish has been increasing throughout the United States. Further, by marketing the product under the Gulf Coast Fisheries name and capitalizing on its reputation for quality and freshness, management now believes there is a good chance that the pro- ject could be financially successful. Finally, some of GCF’s executives believe that it simply must make a strategic change if it is to reverse the downtrend in profits. Gulf Coast’s managers are examining two alternative proposals for entering the catfish mar- ket. Plan L (for large) calls for the immediate development of a large facility that would house the entire fresh fish processing division—catfish holding ponds, a hatchery, a major processing plant, research and development (R&D), marketing, and general management. Plan S (for small) calls for Copyright © 1994. The Dryden Press. All rights reserved.
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the initial construction of a smaller, unsophisticated, no-frills processing plant with limited capacity, and fewer holding ponds, followed in 3 years (if the project is successful) by an expansion to a facility similar to the one called for under Plan L. If the large plant is built immediately and demand is high, the per unit cost of catfish will be lower than if the small plant strategy is adopted. That would permit the company to sell catfish at a price that is low relative to competitive products, especially other seafoods and chicken, and still earn its cost of capital. To date, GCF has spent $1 million on R&D, including both design and marketing studies, on the catfish project. Of this amount, $400,000 has been expensed for tax purposes, while the remain- ing $600,000 has been capitalized and will be amortized over the first 3 years of the operating life of the new facility. According to an IRS ruling specifically requested by GCF, the capitalized R&D expenditures can be immediately expensed if the catfish project is not undertaken. If GCF decides to go forward with the project, it will require a 50-acre site by December 31, 1995 (t = 0). (It will utilize the same site for either Plan L or S.) The firm has decided to locate the facility on the Gulf coast in Pascagoula, Mississippi, because a relatively warm, year-round climate is required for optimal catfish growth and also because the largest growth in demand for catfish con- tinues to be in the South. The firm currently owns a suitable tract of land along the Pascagoula River, which empties into the Gulf of Mexico. The tract cost GCF $500,000 several years ago, but it could be sold now for $1.5 million, net of realty fees and taxes. Other suitable sites could also be purchased for $1.5 million. The site currently owned was purchased by the Shrimp Division, which plans an expansion in 2001. If the site is used for the catfish project, GCF would have to make other arrange- ments for the Shrimp Division. GCF can obtain an option on a similar site in the same area for a cost of $100,000 to be paid on December 31, 1995. The option would give GCF the right to purchase the site on December 31, 1999 (t = 4) for $1.9 million. It is estimated that this and similar sites will experience appreciation of 9 percent annually, and the purchase could always be made at that time for the Shrimp Division should the currently owned tract be used for the catfish project. This land could probably be sold at any point in the project’s life for its appreciated value at that time should the project be abandoned. State, county, and city approvals have already been obtained. Construction would take place during 1996 at a cost of $5 million for Plan L and $2 million for Plan S. For planning purposes, man- agement assumes these expenditures would occur on December 31, 1996. The Plan L plant would have a capacity of 22,000 tons; the Plan S plant would have a capacity of 9,000 tons. The buildings would fall into the MACRS 31.5-year class, and GCF could begin to depreciate them during 1997, the year either plant would go into service. The second stage of Plan S would require additional construction at a cost of $4 million, assumed to be paid on December 31, 1999, and the expanded plant would commence operations on 1/1/2000 and provide cash flows beginning on 12/31/2000. The addition to this plant would increase capacity to 21,000 tons. It too would be depreciated over a 31.5-year life, beginning in year 2000. Although the depreciable life for each plant is 31.5 years, Gulf Coast assumes that it would actually operate the facility for only 7 years, regardless of which plant is selected. There is a good chance that the company would sell out to a larger corporation by then. In addition, management prefers not to project operating lives of more than 7 years, but to calculate a terminal value as of the end of year 7. Production would begin on January 1, 1997, and operating cash flows (end of year) are assumed to begin on December 31, 1997, and to run through December 31, 2003, or 7 years in total. Gulf Coast estimates that the land would have a market value of just under $3 million at the end of 2003, based on the assumed 9 percent appreciation rate. At that time, the buildings could proba- bly be sold for about half their book value. The required processing equipment would be obtained and installed during 1996 at a cost of $10,000,000 for the large plant and $6,000,000 for the Plan S plant. Assume that this payment would be made on December 31, 1996. The equipment falls into the MACRS 7-year class. Plan S would require an additional $6,000,000 of equipment for its second stage; this equipment would be paid for on December 31, 1999, and Stage 2 operations would begin on January 1, 2000. As with the build- Case: 16A Capital Budgeting with Staged Entry
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