The management of Metal Fabricating and Recycling (MFR) had enjoyed an extended period of revenue and earnings growth This period of strong performance lasted for the past four years and showed compound average annual growth of 12 percent JvfFR's management was convinced that the recent strong growth was due to the company's entry into the recycling business and to its careful cultivation of its overseas customers.

MFR was a maker of heating and air-conditioning ductwork for commercial buildings and large residential buildings. The firm, in general, a subcontractor on large building projects, had a strong reputation in the region in which it operated. That region was the area of the United States bounded by Buffalo, New York, and Cleveland, Ohio, in the north and Louisville, Kentucky, and Evansville, Indiana in the south. That area was the primary industrial region in the United States in the period from early in the twentieth century to the 1970s. The decline since that time had abated somewhat, and the region was believed to be at least "holding it's own" in terms of economic viability. In any case, : MFR operated in this environment from a position of dominance.

In terms of its operational strength and reputation, once the firm was contracted to participate in a construction project, its usual practice was to attend to the specific needs of the project through careful selection of materials. The desire was to pay special attention to the specific demands of the design, function, and purpose of the building and to the particular demands of the construction company. MFR designed, constructed (fabricated), and installed its product. Moreover, it guaranteed its work in a manner that assured a high level of serviceability for years to come.

In addition to its ductwork design and installation, the firm was also engaged in the reclamation of sheet metal, primarily ductwork, during the demolition of commercial buildings or large residential buildings. This recovered sheet metal was compressed into stacked sheets and sold directly to recycling companies. This portion of the business was highly profitable, and company management was considering ways in which to expand it geographically.

In addition to its dominance in its own geographic area, MFR had a very solid presence in an industrial region of France, the area roughly north of Paris and toward the Belgian border.

In fact, this region was similar in terms of economics to the area in the United States in which MFR operated. It was believed by some observers, however, that recovery, or at least a strategy for an economic recovery, was not as well developed in the French region as in the US. the region, known in the 1980s as the "rust belt"

In any event, therevenuefrom11FR's sales to its French customers were becoming an increasingly important part of its total revenue stream. An estimated 35 percent of the firm's cash flow would come from the overseas operation over the next three to five years. This was due to the gradual restoration of the French industrial region - unemployment was quite high in the region - and to MFR's well-established reputation as a reliable company. Table 1 outlines the firm's cash flow for the past year.

TABLE 1 Metal Fabricating and Recycling Statement a/Cash Flows 1995 ($000s)
Net income	$2,040
Depreciation	1,740
Increase acc. pay	520
Increase accruals	170
Increase acc. rec.	(1,040)
Increase inventory	(3,480)
Net cash flow from ops.	(50)
Fixed asset acquisition	(4,000)
Increase in notes payable	870
Increase in bonds	3,030
Payment of c/s dividends	(1,070)
Net cash flow from the fin.	(1,220)
Net redan. in cash & near cash	(1,220)
Cash & near cash; the beginning of the year	1,390
Cash & Near cash; end of year	170

An assessment of the individual items for the firm's end-of-year cash flow determination caused Janet Dagna, the: firm's controller to reflect once again on the issue of risk management. This issue had been the topic of heated debate recently between Dagna and her assistant John Taber. The topic of concern was that of managing (defining, measuring, and assessing the effect on the firm's value) the risk of the firm's overall cash flows, and the overseas cash flows in particular. Again the items are shown as captions in Table I set Dagna to thinking. What actually caused the variability in the overseas net income? For example, what effect did some of the other items on the cash flow statement have upon the end-of-year cash balance?

In addition to the concerns related to cash flow, Dagna and Taber wondered how the discount rate used to find the present value of cash flows might be better used to define and measure risk Table 2 provides the latest balance sheet for the firm. The balance sheet data for the previous two years is not significantly different from Table I, except in terms of depreciation's effect on buildings and equipment, and the change in retained earnings.

TABLE2 Metal Fabricating and Recycling Balance Sheet December 31,1995 ($000s)
Total.current assets	$1,066	Total current liabilities	$ 43
Land and buildings	(net) 45,288	Long-term debt @ 8%	28,971
Equipment (net)	16,250	Common stock ($10 par)	26,640
Total fixed assets	61 538	Retained earnings	6 550
Total assets	$62 604		$62 604

The company's stock price is now$40 per share and the dividend expected in the next period is $2.50. The 15-year $1,000 bonds outstanding since 1992 are selling at par. The tax rate for MFR is 30 percent

It was clear to Dagna that the standard method of defining and measuring risk in the finance literature was the variability in expected cash flows and the variance, standard deviation, and coefficient of variation, respectively. Of a more pressing concern, however, was the relative variability of the items in Table I. Was any one of the items more variable than another, and if so which- ones?

Question 

What is MFR's weighted average cost of capital? Is this a likely number for use as a discount rate in capital budgeting?

Answer rating: 100% (QA)

Was any one of the items more variable than another and if so which ones The other concern was the effect of the forecast growth rate on the standard deviation It was clear that the forecast growth ra... View the full answer