HOBBITON FARM

 

Hobbiton Farm grows corn, which it sells for $4per bushel. Variable costs are$1 per bushel; fixed costs are $4.8 million. All costs and revenues are in cash. The only asset on Hobbiton’s balance sheet is land, which has both a book value and market value of $15 million. Hobbiton has no debt and a cost of equity capital of 12%. This represents a 4% risk-free interest rate plus an 8% premium that investors expect in exchange for bearing the risk of the investment. All earnings are distributed to the owners in the form of dividends. There are no income taxes

 

Part I:

 

  1. What is Hobbiton’s break-even point?
  2. Suppose Hobbiton’s produces and sells 2.5 million bushels of corn. Find Hobbiton’s accounting income, return on equity (ROE), and residual income.

Is Hobbiton’s doing better, worse, or about the same as expected?

 

Part II:

 

Hobbiton is considering buying a wheat field. The land would cost $5 million and generate annual cash flow and accounting income of $700,000.

 

  1. Given Hobbiton still produces and sells 2.5 million bushels of corn on its existing farm, what happens to Hobbiton’s ROE and residual income if it purchases the wheat field?
  2. Is the investment a good idea? Why or why not?

 

Part III:

 

Suppose Hobbiton does not buy the wheat field. Hobbiton produces and sells 2.2 million bushels of corn.

 

  1. Find Hobbiton’s return on equity and residual income.
  2. Suppose instead of being an all- equity firm, Hobbiton’s assets were financed with $7.5 million of 4%, riskless debt and $7.5 million of equity. Find Hobbiton’s accounting income, return on equity, and residual income.
  3. Has firm value increased due to leverage? If so, provide an intuitive explanation regarding the source of the increase in value.

I’m looking for economic intuition, not a calculation.

 

 

Part IV:

Suppose Hobbiton remains an all-equity firm, does not buy the wheat field, and produces and sells 2.5 million bushels this year.

 

An Economic Value Added (EVA) analysis reveals that of the $4.8 million of annual fixed costs, $1.5 million are advertising expenditures that create a valuable brand for Hobbiton. The value of these expenditures decay at a 20% rate over time, and so for EVA purposes, advertising is capitalized and amortized at a 20% rate. The estimated value of Hobbiton’s brand at the start of the year was $7.5 million.

 

  1. Find Hobbiton’s EVA for the year.
  2. Has your assessment of Hobbiton’s performance changed?

 

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