Florida Power & Light - Casebook

Capital Budgeting: Renewal versus Replacement

Florida Power & Light (FP&L) is the primary subsidiary of Florida Power & Light Group,

representing 97% of their operating revenues. FP&L is a utility company that supplies electric service throughout most of Florida's eastern seaboard. Their service area contains 27,605 square miles which translates into approximately 3.4 million customers. Of these 3.4 million customers, as a percentage of operating income, roughly 55% comes from residential

customers, 35% from commercial, 4% from industrial, and the remaining 6% from other sources.

Paul Seiler, a senior contracts agent in the nuclear division at FP&L's Turkey Point Plant in Florida City, Florida, is debating on whether to renew or replace the commercial nuclear reactor's reactimeter. A reactimeter is a vital component of the nuclear power generating process.

The core of a nuclear reactor must be maintained at a certain temperature and must possess a particular chemical composition. Any deviation from this sensitive optimal mix will result in the sub-optimization of the plant and a corresponding waste of energy. The reactimeter is a computer with accompanying software that is used to monitor the requisite characteristics of the Reactor Coolant System (RCS) and make minor adjustments as needed.

Alternative 1:

In order to determine whether the reactimeter should be renewed or replaced, Paul had to gather some financial information. If the current computer system is upgraded and new

software is purchased, the cost will be $80,000. An additional $5,000 will be required to have the system installed and calibrated for accuracy. The renewed computer system will have a useful life of just five years and will be depreciated in compliance with the MACRS five year recovery system. Depreciation rates for years one through five are .20, .32, .19, .12, and .12, respectively. Only the purchase cost of $80,000 will be depreciable, not the installation cost.

At the end of the five year period, the renewed machine can be sold for $5,000 before taxes.

The renewed machine would also result in an increase in net working capital of $20,000. Net profits resulting from an increase in operational efficiency for each year will be as follows:

Table 1

Year Net increase in profits

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1 $650,000

2 $425,000

3 $317,000

4 $220,000

5 $129,000

Alternative 2:

The new system will also have a five year life and will be depreciated in compliance with the MACRS five year recovery system. The fully depreciable cost of the new system will be

$100,000. Installation costs will be an additional $5,000. At the end of the five year period, the renewed machine can be sold for $10,000 before taxes. Implementing the new machine

would result in an increase in net working capital of $15,000. If FP&L decides to replace the old system with a new reactimeter, the resulting net profits will be:

Table 2

Year Net increase in profits

1 $350,000

2 $350,000

3 $350,000

4 $350,000

5 $350,000

If a new system is purchased, the old system can be salvaged for $10,000. Finally, FP&L has a 40% corporate tax rate.

Questions

1.

What is the initial investment associated with both alternatives?

2.

Calculate the net after-tax operating cash inflows associated with both alternatives.

3.

Calculate the year 5 cash flow associated with the sale of the computer for both

alternatives. That is, remember to consider that both computer systems can be sold at the end of the fifth year.

4.

Using a discount rate of 10%, calculate the present value of both alternatives. Which alternative should Paul choose?

5.

What are some of the qualitative factors to consider when making a decision between the two alternatives?

aw_gitman_pmf_10|Case Studies in Finance|Case 22: Florida Power & Light

6.

Based on your answers from questions 4 and 5, has your decision changed concerning which alternative is preferred?

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aw_gitman_pmf_10|Case Studies in Finance|Case 35: REITs

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Case 35: REITs

Real Estate Investment Trusts

REITs have been in existence since 1960. However, it wasn't until around 1992 that they became popular. A REIT is a securitized form of owning real estate. Before REITs, the only way to experience the risk and return associated with commercial real estate was to own it directly through property pools, commingled real estate funds (CREFs), syndications, or separate accounts. Today, you can buy a REIT, which represents ownership in a company that holds real estate as their primary assets.

REITs are real estate stocks and are traded on the NASDAQ, AMEX, and NYSE. As such, they are exposed to market noise like any other stocks, but are also similar to their underlying assets, real estate. This makes the capital gains component of their returns very attractive as a hedge against inflation, a characteristic much desired by investors.

Moreover, since a minimum of 90% of a REIT's taxable income must be paid out in the form of a dividend, investors liken the income stream to utility stocks that also pay a high

percentage in dividends. Finally, REITs have a low correlation with other stocks, bonds, etc.

and therefore have been found to warrant inclusion in mixed-asset portfolios. But, even with their steady returns and low volatility, REITs have received little attention from the investment community.

One of the reasons why REITs are given little attention is because there are only 188 in

existence today. While this is three times greater than the number just ten years ago, the total market capitalization of all REITs is still less than that of Microsoft. As such, analysts have not considered them worth the time to monitor and evaluate.

That being said, REITs are being used by several real estate portfolio managers as a way to rebalance their portfolios over time. Why? Unsecuritized real estate, such as a $50 million dollar office building in downtown Chicago, is an illiquid and lumpy asset. That is, if you want to sell $1 million dollars of it, it would not be possible. You would have to be able to sell off just one or two floors of the building. Since this is not possible, institutional investors might

instead sell off $1 million worth of an office REIT.

Whether or not REITs gain widespread acceptance and continue to perform well remains to be seen. Still, at present, REITs do offer an attractive risk-return tradeoff.

Questions

aw_gitman_pmf_10|Case Studies in Finance|Case 35: REITs

1.

Why would you suspect real estate is a good hedge against inflation?

2.

Which types of investors are more likely to own REITs?

3.

REITs have had a lower correlation recently than in the past. Explain why and justify whether or not you think this trend will continue.

4.

Does the fact that the total market capitalization of all REITs sums to less than that of Microsoft present a problem for real estate portfolio investors who are trying to use REITs to rebalance their large portfolios? Explain why or why not.

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aw_gitman_pmf_10|Case Studies in Finance|Case 36: HOLDRs

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Case 36: HOLDRs

New Security Offerings: HOLDRs versus UITs

A new type of security, known as a HOLDR, is now available to investors. The first HOLDR was introduced by Merrill Lynch in September of 1999. Since then three more have been offered, and given their early success, this trend is likely to continue.

A HOLDR is similar to a Unit Investment Trust (UIT) in that both are unmanaged baskets of securities that can be redeemed for their underlying assets. The primary differences involve pricing and trading. UITs are like mutual funds in that their price is calculated once a day, at the end of each trading session. HOLDRs, on the other hand, trade like stocks in that their price changes continuously during trading hours. This is an added attraction in today's environment of so many day traders.

The second major difference is that it is not difficult to find the price of a HOLDR. HOLDRs have a ticker symbol which means it is very easy to track their prices - say from various Internet sites. UITs do not have ticker symbols. Investors are often forced to call brokers or the trust sponsor to get pricing information. In response to the new, much more convenient HOLDR security, a UIT industry representative states, "It's being discussed among the major broker/dealers and sponsors, and we want to implement them (ticker symbols) as soon as possible."

Other differences between the two types of secureties include changes in the composition of portfolios (HOLDRs are completely fixed, whereas UITs can add securities - particularly ones that track indexes), sales charges (HOLDRs are very similar to common stocks, whereas UITs are quite complex and vary from UIT to UIT), and time to maturity (HOLDRs, like common stocks, have no expiration, but UITs have a finite life).

While it is difficult to draw definite conclusions as to which type of investment vehicle is better for investors, HOLDRs do seem to have caught the attention of UIT sponsors. What we do know is that Merrill Lynch plans to offer more of these stock bundles in the future. Whether HOLDRs will cut into the volume of UIT trading, simply attract more capital into the markets as a whole, or at least provide a financial incentive for the UIT industry to improve upon the transparency and availability of price data for their products remains to be seen.

Questions

1.

What causes firms, like Merrill Lynch, to offer new variations of existing securities?

aw_gitman_pmf_10|Case Studies in Finance|Case 36: HOLDRs

2.

When compared to UITs, why would HOLDRs attract more day traders?

3.

Do you think it is a coincidence that the UIT industry is starting to offer better price availability now that HOLDRs have emerged? Explain.

4.

The HOLDRs introduced thus far by Merrill Lynch have been industry specific (Internet - HHH, Biotech - BBH, Telecom - TTH, and Pharmaceutical - PPH).

Considering diversification, is it enough to hold just one type of HOLDR? Explain.

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aw_gitman_pmf_10|Case Studies in Finance|Case 37: Reynolds

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Case 37: Reynolds

Mergers and Takeovers

Strap your seatbelts on, keep your hands inside the vehicle and hold on for dear life. The merger mania roller coaster that has been so prevalent in today's market is going for another ride. Just hours after a three-way $17.6 billion mega-merger was announced between

Canada's Alcan, Pechiney of France, and Switzerland's Algroup, U.S. based Alcoa, the world leader in the aluminum industry, announced plans to buy Reynolds Metal for $5.6 billion. If the merger between Alcoa and Reynolds, the third largest aluminum firm, were to happen it would make the resulting Alcoa by far the market dominator.

There are two things standing in the way of the Alcoa-Reynolds merger. Since the union of the two giants would result in a market leader akin to Microsoft in the computer industry, and because competition would be drastically reduced, there are several regulatory anti-trust concerns. The second potential hold up involves the degree of willingness on the part of Reynolds' management to be purchased by Alcoa. Since mergers also mean layoffs, managers are always cautious about merger deals.

But mergers also mean large stock price increases for the firms who are the target of merger and takeover attempts. Therefore, most stockholders prefer their company to be the topic of bidding speculation. In fact, Highfields Capital Management LP, Reynolds' single largest stockholder, has taken the initiative to foster further merger consideration. They are pressuring Reynolds' management to arrange an auction to the highest bidder.

Highfields Capital's managing director, Richard Grubman, wrote a letter to Reynolds' CEO, Jeremiah Sheehan stating, "Your shareholders deserve nothing less and will hold you accountable if you fail to take this action now." Fearing derivative shareholder action and accepting what seems to be the inevitable, Reynolds appears to be open to listen to deals from anyone and everyone.

So where do the smaller firms in the aluminum industry fit into all this? Industry analysts

report that these firms are scrambling in an attempt to be a part of deals while the market is in a state of frenzy. The fear of being left out could be a rational one as many feel bidding wars result in over paying for firms.

Just when things could not be more unpredictable, an outside player has announced

intentions to challenge the bid of Alcoa for Reynolds Metal. Michigan Avenue Partners (MAP), a firm who got their start in commercial real estate, has come out of the woodwork to

announce interest in Reynolds. MAP is not exactly a stranger to the aluminum industry, however. A few years ago they bought Reynolds' McCook division and are now the second

aw_gitman_pmf_10|Case Studies in Finance|Case 37: Reynolds

largest producer of aluminum plating (behind Alcoa). They also own Metro Metals which is a steel processing firm. Still, analysts did not even see MAP on the bidding radar screen.

The next few months will prove telling for this capricious environment. Said John Martin, aluminum industry analyst at the CRU consultancy in London, "Nothing would surprise me."

Questions

1.

Why is it that firms like Alcoa desire to merger or buy other large firms in the same industry like Reynolds?

2.

Why might regulators have a problem with firms like Alcoa buying firms like Reynolds?

3.

What are the general reasons why firms merge?

4.

What can firms do to prevent a takeover attempt from an unwanted suitor?

5.

How are funds raised to complete a merger between two such large firms?

6.

In the case it stated that several of the smaller firms in the industry wanted to be considered as bidding candidates because bidders tend to pay over fair market value for the smaller firm's shares. Why does this happen?

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aw_gitman_pmf_10|Case Studies in Finance|Case 38: Adaptec

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Case 38: Adaptec

Corporate Spin-offs

Brian Reeves opened his mailbox to find a letter from Adaptec, Inc., a global leader in data storage access solutions, which had cost him a lot of heartache in the recent 6 months. After being enticed to purchase shares in high-tech companies after they enjoyed a significant run-up in value, Brian jumped on the band wagon only to see the value of the stock get cut in half.

The letter read, "Adaptec, Inc.,... announced that the Form 10 Registration Statement for the spin-off of Roxio, Inc., a wholly owned subsidiary of Adaptec, has been declared effective by the Securities and Exchange Commission. Included in the Form 10 is an Information

Statement, which will be mailed to Adaptec stockholders later this week…" Skipping over a few sentences, Brian continued.

"On April 12, 2001, the Adaptec board declared a dividend to Adaptec stockholders of record on April 30, 2001, of shares of Roxio common stock. The dividend will be paid after the close of business on May 11, 2001, in the amount of 0.1646 shares of Roxio common stock for each share of Adaptec common stock. Adaptec stockholders will not be required to pay any cash or other consideration for the shares of Roxio common stock distribution to them or to surrender or exchange their shares of Adaptec common stock to receive the dividend of Roxio common stock."

After reading through all the documents, Brian learned that there are two ways to trade the Adaptec shares between the date of record, April 30, and the distribution date of May 11. He could either trade the "regular way," which meant when he sold a share of Adaptec, he would also be selling the right to the shares of Roxio (Ticker symbol = ADPT), or he could sell "when issued," which meant that he is only parting with shares of Adaptec (Ticker symbol = ADPTV).

That is, he would retain the rights of owning shares in Roxio when they became available for sale.

Questions

1.

Brian wondered why he did not have to do anything in order to be awarded shares of this new company, Roxio. Explain why it makes sense that he did not have to do anything.

2.

Assume Brian owned 100 shares of Adaptec. Based on the ratio of exchange of 1 share of Adaptec = 0.1646 shares of Roxio, how many shares of Roxio will Brian receive assuming he retains his Adaptec shares?

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3.

To follow up from question 2, what will happen to the rights to FRACTIONAL shares?To follow up from question 2, what will happen to the rights to FRACTIONAL shares?

That is, after calculating the number of shares Brian is to receive, what happens to the That is, after calculating the number of shares Brian is to receive, what happens to the extra fraction of a share given that with common stock, fractional shares ownership is extra fraction of a share given that with common stock, fractional shares ownership is disallowed?

disallowed?

4.

Continuing with the fractional share discussion, what are the tax ramifications of theseContinuing with the fractional share discussion, what are the tax ramifications of these fractional shares?

fractional shares?

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Roxio, a wholly-owned subsidiary of Adaptec, recently finalized its decision to become a Roxio, a wholly-owned subsidiary of Adaptec, recently finalized its decision to become a completely separately traded corporation. In their own words, Roxio describes themselves as completely separately traded corporation. In their own words, Roxio describes themselves as

"... a leading provider of digital media software solutions that enable individuals to create,

"... a leading provider of digital media software solutions that enable individuals to create, manage and move music, photos, video and data onto recordable compact discs, or CDs.

manage and move music, photos, video and data onto recordable compact discs, or CDs.

Our principal products are our East CD Creator and Toast families of CD recording software Our principal products are our East CD Creator and Toast families of CD recording software

In document Casebook_FINANCE (Page 85-98)