FINANCE

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Moon Bakery

The Moon Bakery Corporation was originally founded in Dallas, TX in 1991 by Jay Kaplan, who currently

serves as the company's Chief Executive Officer. About four years ago, Kaplan's daughter, Jane, moved

into the company to serve as Chief Financial Officer. Jane had graduated from college a few years ago

and had worked for a few years in retail. However, for the past two years, she had been working quite

successfully on an online accounting degree, but she still felt a little uncomfortable in her new role as

CFO of the family business.

Moon produces and markets a variety of bakery products throughout southeast Texas and Louisiana.

They operate mostly through warehouse delivery and produce fresh breads, buns, rolls, and snack

cakes under a few of their own regional brands but also including some licensed "big name" national

brands. In total, they operate five bakeries with one very large facility and four smaller production

sites. For the past three years, sales have averaged about $15 Million, generating about $650

Thousand in Net Income per year. However, sales have been roughly flat for the past six years as

growth has slowed and production capacity has reached nearly 100%. In order to grow sales, Moon

Bakery needs to invest in further production capacity.

Jay Kaplan has been looking to purchase more space, build additional bakeries, or even perhaps acquire

one of their smaller competitors, but nothing specific has worked out yet. Jane has an alternative

short-term plan to modernize the production process at their main plant. Her idea involves the

purchase of a new, significantly faster, integrated commercial oven that she recently saw displayed at a

trade show. Few other bakeries in the region have invested in this modern equipment, and she expects

it may cut costs and improve output efficiency. Her sales representative suggests the new oven could

raise incremental sales at their large bakery by 15%.

Installation of the oven could be mostly executed over the upcoming Labor-day long weekend and

shouldn't disrupt sales or production too much. However, the new oven requires an expenditure of

$300,000, which would be a large capital expenditure for Moon. To reflect the wear and tear on the

oven, tax law allows for a 10% annual reduction in the value of the oven as a depreciation expense.

That is, Jane’s financial forecast includes a non-cash expense of $30,000 for each of the next six years.

After six years, Jane’s sales representative expects sell the oven at about $120,000, which is just equal

to the accounting book value of the oven after six years of accumulated depreciation ($120,000 =

$300,000 – 6 * 10%*$300,000).

Operation of the oven also requires a small initial investment in an inventory of spare parts of $15,000.

The inventory should be fully recoverable for $15,000 if the machine is sold. The investment in

inventory represents an increase in other current assets (inventory) that should be included as a

change in working capital requirements for Moon Bakery. Moon estimates receivables at 1.5% of

revenues and payables at 2% of revenues each year. At the end of the project, Jane expects to recover

all of the working capital invested in the project. In other words, she expects a cash flow equal to the

amount of Non-Cash Current Assets less Current Liabilities in the last year of the project.

Jane’s financial forecast for the new oven does not require any significant change in financing. Moon

started with one small bakery entirely paid for with cash from Jay Kaplan and a mortgage on the bakery

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property. Currently, Moon maintains a rough. In Jane's forecast, she expects to purchase the new

oven using debt and common equity as it plans to finance the expansion at its target capital structure

of about 30% debt and 70% equity. Moon currently pays about 4.2 % on their debt, and that rate is

not expected to change with the additional purchase of the oven.

Jane remembered from her online classes that she needs to assess the risk of her business when

making important financial decisions. In researching similar large public bakery and other food

manufacturers, she found that firms in her industry with about the same level of risk mostly had stock

market betas around 0.70 on average. She also noted that many analysts used a ballpark equity risk

premium of 5.5% and a current yield on U.S. treasury bonds (risk-free rate) of about 3%. Moon has a

corporate tax rate of 30%.

To help understand the costs and benefits of the decision, Jane worked closely with her director of

operations, plant manager, marketing team, and her father to produce some realistic sales, costs, and

financial forecasts. Her team felt uncomfortable forecasting more than 5 or 6 years into the future.

Her focus was on how the new oven might improve incremental revenue generation at their large

plant. The case exhibits below contain Jane's financial projections for the project.

In discussing her plan to purchase the new oven, Jane's father seems more than a little worried that the

new machinery is not worth the cost and that Jane's motivations may not be based on sound financial

decision making. As Jane looked over the financial forecasts, market data, line of credit agreement,

and the intimidating $350,000 invoice that would soon follow, she wondered how she could convince

her father, and herself, that purchasing the new oven would be a sound financial decision.

Moon Bakery Case objectives

In this case analysis, our objective is to bring together all the tools we covered throughout the course

incorporating discounted cash flows, estimating free cash flow forecasts, analyzing the cost of capital

and computing various capital budgeting tools. The aim of this case study is to put the tools and

concepts we have developed into a more real-world and practical setting.

Using this information given in the case, your job is to figure out whether or not to undertake the

expansion project by computing all of the capital budgeting tools that we covered. Please answer the

questions using the financial statement forecast given in Exhibit 1. Note that you will need to calculate

the working capital and net increase on working capital along with the free cash flows for each single

year.