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| |Harris Seafoods Inc. | Memorandum To:Mr. Charlie Harris II, CEO From:student 103 CC:Professor Date:11/22/11 Subject:Harris Seafoods Inc. : Processing Plant Project Analysis and Recommendation Your immediate attention is requested. We would like to take this opportunity to discuss our team valuation of accepting Processing Plant Project. We value that Harris Seafoods has evolved into one of the largest producers of frozen shrimp in the United States.
We are impressed by company’s remarkable high return on equity of 39% after-tax. Our analysis of the Processing Plant Project will help you make a well informed decision and additionally, it will provide an action-oriented recommendation. We will first identify key issues and risk involved followed by financial support of the project. Our analysis is supported with financial measures of NPV, IRR, CAPM theory and WACC to illustrate if accepting Processing Plant Project would provide acceptable required rate of return for Harris Seafoods.
Key Issues and Risk: The processing Plant proposal would allow Harris Seafoods to seize the opportunity to expand into shrimp production and sales while utilizing its resources effectively. The expansion in shrimp processing facility would permit the company to grow in terms of return on investment. However, we would like to highlight various risk exposed to Harris Seafoods Inc by accepting the project. We believe that by accepting the project would affect Harris Seafoods high return on shareholder’s equity.
Issues in Shrimp Industry:
The Shrimp Industry appears to be uncertain in terms of shrimp supply. The shrimp beds in the waters off Texas and Mexico were over fished, resulting in it becoming increasingly difficult to find shrimp as stated on page two. It exposes Harris Seafoods to the risk of shortage in shrimp supply. The price of shrimp is determined by the size, the value of the catch and production levels are beyond management’s control. The price risk is vital to consider. The demand for shrimp is affected by the cyclical swings due to changes in the economy which also impact prices.
As a result, the changes in supply leads to an increase in shrimp imports into the US since foreign competitors tend to have lower costs than fisherman within the US. Another major issue is the unpredictable shrimp supply. The supply of shrimps is risky due to the danger of being destroyed from oils spills from offshore drilling activity. Harris Seafoods also faces an existing threat with territorial limitations since most countries of the world have established 200-mile boundaries, as a result it limits the number of overseas boats allowed to fish in boundaries areas.
One more issue and risk to consider is fluctuating and irrepressible cost of fuel expense for operating of boats and equipments. The Processing Plant Project: The processing plant proposal seem attractive and if Harris Seafoods decides to expand its operations in shrimp processing, the project will cost $7 million and can be completed by the first quarter of 1981. However, we encourage Harris Seafoods to consider if accepting the processing plant would meet Harris Seafoods required rate of return on shareholder’s equity.
Using WACC, we determined discount rate of 15% – 20%, the discount rate that company is expected to pay for all its bonds and stockholders to finance its assets. Using the long-term government bond as a bench mark, we concluded that risk free rate, an acceptable required rate of return, to be above 13. 521%. The inputs for WACC were 30% debt to a 48% tax rate which concluded to be 15%. Please note that 39% required rate of return from Harris Seafoods is very high and not common. Therefore, we feel that 18% rate of return is acceptable using CAPM.
We calculated Required Rate of Return by using Capital Asset Pricing Models with inputs of treasury long-term government bonds (9. 44%), return on equity—all US manufacturing companies (16. 3%), and Harris Seafood’s beta (1. 25). Please be advised that 1. 25 beta for Harris Seafoods equity, but we acknowledge that true beta of the project is uncertain because of finding a market portfolio with similar risk is hard to find. In addition, the Return on Equity at 15%, we took the discount rate and applied it to the Free Cash Flows to get a Net Present Value.
The Internal Rate of Return of the project was 15%. To compensate Harris Seafoods for the opportunity cost and risk of not investing in lowest required rate of return plus risk premium for individual’s required rate of return, we will use WACC of Harris Seafoods. Our Recommendation: We recommend based on economical analysis determines that accepting processing plant project is not viable to meet the minimum required rate of return set by the Harris Seafood Inc. for shareholder’s equity.
Your concerned about accepting this project would reduce the company’s high rate of return on invested capital is absolutely correct after this analysis. The Free Cash Flow provides a possible scenario of receiving certain principle and interest payments that Harris may receive. Please be advised that our Cash Flow projects and forecast provides great uncertainty, consequently we compensate that uncertainty with the discount rate of 15%, the higher discount rate resulted in lower present value which means our project will be worth less.
Please keep in mind that a negative NPV does not ultimately define poor investment, but rather, from an economic perspective a negative NPV signifies the investment will not return the expected required rate of return or neither will it compensate for opportunity cost missed as an investment elsewhere. Our Free Cash Flows concludes that Harris Seafoods would experience negative Free Cash Flow in 1980 of $10,035. 00 and continues to experience negative free cash flow for following years up to 1986, which results in negative present value.
However, 1981 Harris Seafoods took a tax credit in the amount of $650,000 that declined present value for the years. We don’t recommend investing in the Shrimp Processing Plant because of the tax incentives offered by Brownsville, Texas. We also suggest Harris Seafoods to consider industry (supply and demand) risk, oil price risk, cycle risk, import and export risk, weather risk, and operating (oil-spill risk and storage cost) risk.
Harris Seafoods has been successful, profitable, and maintained a high required rate of return. Although, we recognize by diversifying business risk by investing in processing industry would allow Harris Seafoods expand in business operations. In addition, we highly want Harris Seafoods to contemplate the critical risk factors of supply, demand, and price of Shrimp. We hope this analysis and recommendation is adequate. If you have any question, please free to contact any of our team members.