FIN5003 Module 6 finance committee memo example

Memo to the Finance Committee: Approve the Freezer Facility on Four Conditions, Financed With 30 Percent Debt

Student Name

American College of Education

FIN5003: Financial Decision Making

Module 6 Assignment

Instructor Name

August 7, 2028

Decision Requested

To the Finance Committee, Fenwick Cold Chain, from the Director of Finance. The committee is asked to approve construction of the 40,000-pallet freezer facility at a total cost not to exceed $69.0 million, financed with a $20.4 million bank term loan and about $48 million of owners' equity, subject to four conditions set out below. Fenwick is a composite company, and every figure in this memo is invented for teaching. If the conditions cannot be met by the date the construction contract must be signed, management will return to the committee rather than proceed. The committee is not being asked whether the project is attractive; it is being asked whether it is attractive enough once its risks are protected.

The Numbers

Discounted at the 8.8 percent rate the company now uses, the project's net present value is about $3.2 million and its internal rate of return about 9.3 percent. Most of the value depends on two assumptions: the customer renewing in year 15 and the facility's resale value in year 20. Should the customer keep only half its space after year 15, the project would lose roughly $16 million in present value. The refrigeration system selected, carbon dioxide, saves roughly a third of a million dollars a year against ammonia once the two systems' lives are put on equal terms and is included in these figures.

The project's value is thin relative to its size. The contract price could slip by less than 80 cents a pallet a month before the value vanished, and its break-even construction overrun about 4.7 percent. A simulation using Fenwick's own history of overruns and slow lease-up produced an average net present value of about negative $3 million; with the protections below, the average rose to about $0.7 million. Brealey et al. (2023) note that a positive net present value is only as reliable as the forecasts behind it, and Kahneman and Lovallo (1993) documented the tendency of managers to make optimistic forecasts for projects they sponsor. The committee should read the base case with both points in mind.

Four Conditions

Management recommends approval only if all four conditions are met before the construction contract is signed. First, renewal protection: either twenty years of initial commitment, or fifteen years plus a five-year extension right covering nine-tenths or more of the positions, with a payment owed to Fenwick if the customer walks away. Second, contract price: storage at no less than $22.00 per pallet per month, with concessions, if any, made on term rather than price. Third, cost certainty: a guaranteed maximum price construction contract capping Fenwick's exposure at 1.5 percent above the $68 million budget. Fourth, occupancy: a signed lease with at least one additional tenant for at least 2,000 pallet positions.

Each condition targets an input that the sensitivity and simulation work identified as capable of reversing the decision. Taken together, they convert a project whose average simulated outcome was negative into one whose expected value is modestly positive. Management does not recommend relaxing any condition to win the contract.

Financing

Management recommends financing with 30 percent debt. Early in its life the facility's after-tax return on cost, near 4.7 percent, sits below what borrowed money costs after tax, so heavier borrowing would lower the owners' return while raising their risk. At 30 percent, the bank's debt service coverage covenant of 1.25 holds with room even in the downside case, at about 2.0; at 50 percent, it would fail in the downside. Consistent with the preference for internal funds described by Myers (1984), the equity portion should come first from retained earnings, about $30 million, with the balance from a family capital contribution. Management will also ask the refrigeration maker's finance arm to fund that system separately, which would preserve bank borrowing capacity for the next project.

Risks the Committee Accepts

By approving, the committee accepts three risks that the conditions reduce but do not remove. The facility will concentrate more of Fenwick's revenue in one customer, raising the share from its three largest customers from 58 percent to about 64 percent. Even with the protections, the simulation indicates a roughly 45 percent chance that the project earns less than the cost of capital, though a much smaller chance of a loss large enough to threaten covenants. And the resale value in year 20 cannot be protected by contract; it rests on what refrigerated buildings will be worth to buyers in the late 2040s. Management believes these risks are acceptable for a project that expands Fenwick's largest customer relationship and adds modern capacity in a growing market, but they are the committee's to accept.

Motion

That the Finance Committee approves construction of the freezer facility at a total cost not to exceed $69.0 million, financed with bank term debt of approximately 30 percent of cost and owners' equity for the balance, and authorizes management to sign the construction contract and customer agreement only upon satisfaction of the four conditions stated in this memo, with a report to the committee confirming each condition before signature; and that management report to the committee quarterly during construction on cost against the guaranteed maximum price and annually thereafter on occupancy, net cash flow and debt service coverage against the projections.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2023). Principles of corporate finance (14th ed.). McGraw Hill.

Kahneman, D., & Lovallo, D. (1993). Timid choices and bold forecasts: A cognitive perspective on risk taking. Management Science, 39(1), 17-31. https://doi.org/10.1287/mnsc.39.1.17

Myers, S. C. (1984). The capital structure puzzle. The Journal of Finance, 39(3), 575-592. https://doi.org/10.1111/j.1540-6261.1984.tb03646.x