Submarine Sandwich Page 1 of 6

Submarine Sandwich
Submarine Sandwich is a restaurant chain with outlets throughout the United States. It specializes in
made-to-order burgers and salads on either an eat-in or take-out basis. Fast service is maintained by
having a limited menu, an efficient restaurant layout, and an assembly line "production" of each menu
item. Submarine Sandwich has captured a not unsubstantial percentage of the fast food market from the
industry leader, a hamburger chain, through its emphasis on the fact that fast food does not necessarily
have to be fattening or unhealthy.

Submarine Sandwich was started as a small, family-owned, standup lunch counter in an indoor shopping
arcade across from the campus of the University of Texas at Austin. Its popularity with students was high,
and as each class graduated and moved away from Austin, the word about its quality food spread. As its
reputation grew, operations were expanded throughout the South and the Southwest. Once it had
become apparent that the potential market was very large, Submarine Sandwich acquired a professional
corporate staff to fulfill increasingly sophisticated needs in the area of finance, operations, and general
management. The success of Submarine Sandwich was due in a large part to the hard work and foresight
of the founder. Rudolph Grabowski, and his policy of hiring only competent employees, paying them very
well, and demanding first-rate performance.

Submarine Sandwich was operated as a closely held, family-owned corporation until 1987, when
Rudolph Grabowski, Jr sold approximately 20 percent of the outstanding stock to the public. Since this
original public offering, members of the family have disposed of an additional 50 percent of the stock. In
2006, outsiders owned 70% of the shares, while 30% was still held by the Grabowski family.

Members of the Grabowski family managed the firm until 2000, when Rudolph Grabowski, Jr. retired
from active participation. Since no other member of the family was interested in or qualified to assume a
dominant role in management, Joan Walker, a CPA who was then senior vice-president of another
leading fast food chain, was brought in as president and chief executive officer. Walker considered the
Grabowski management team—the people in operations, marketing, HR and so on excellent, so she did
not institute any major personnel changes when she assumed her position. But she did bring in Arnold
Hansen, a 32-year-old MBA who had been her assistant at McDougal's. Hansen's primary responsibility
was to seek out weaknesses in Submarine Sandwich's operations and then to devise methods for
correcting them.

One of the first things Hansen noticed was the rather haphazard manner in which capital investment
decisions were made. For the most part, capex decisions were authorized by Harold Mikelson, financial
vice-president, without any systematic analysis. Mikelson simply approved all requests for capital
expenditures as the different district managers made them. However, Mikelson did periodically review
the rate of return on investment in the different districts, and if the return for a given district was
seriously below that of the firm as a whole, the district manager was notified that his or her results were
below average and their requests for funds was turned down. As a result of this procedure, managers
with below-standard returns tended not to make substantial requests for expansion funds until their
district's returns were brought up to the average for the firm.

It was apparent to Hansen that this informal procedure tended to cause available funds to be allocated
to districts with the highest return on investment. He also noted that during years when expansion had
been more rapid than normal, such as 1998 and 1999, Mikelson had requested information on the
payback period for the larger capital expenditure proposals. He had rejected

The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2016
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several proposals on the grounds that (1) the firm was short of funds for additional capital expenditures,
and (2) the paybacks on the rejected projects were relatively long compared to those on certain other
alternatives.

In early 2001 Hansen wrote a memorandum to President Walker, sending copies to the other major
executives of the firm (the executive committee), in which he suggested that the capital budgeting
process be formalized. Specifically, Hansen recommended that the firm adopt the net present value
approach, under which projects would first be ranked in accordance with their net present values, and
then all projects with positive net present values would be accepted.

Walker enthusiastically endorsed the proposal, but Hansen detected a certain amount of skepticism
about it on the part of the other senior officers, especially Mikelson. Although Mikelson seemed to
endorse the principle of using a present value approach to capital budgeting decisions, he was uncertain
about the firm's ability to find an appropriate discount rate, or cost of capital, to use in the capital
budgeting process.

Nevertheless, in May 2001 Hansen was directed by the executive committee to develop a cost of capital
for the firm to use in evaluating new capital investment projects. As a first step in this task, he obtained
the projected December 31, 2001 balance sheet (Table 1) as well as information on sales and earnings
for the past ten years (Table 2).

Table 1 Submarine Sandwich Balance Sheet

Projections for December 31,2001

(Millions of Dollars)
Cash and marketable $ 19 Accounts payable a $8
securities
Accounts receivable 94 Bank notes payable (9%) 80
Inventories 120 Total current liabilities $ 88
Total current assets $ 233 Long-term debt b $ 120
Preferred stock c 45
Common stock d 55
Net fixed assets $ 172 Retained earnings 97
Total assets $ 405 Total claims $ 405

Notes:

a. Accounts payable are exceptionally low because the firm follows the practice of paying cash on
delivery in return for substantial purchase discounts.

b. The bonds outstanding have a par value of $1,000, a remaining life of 15 years, and a coupon rate of
9 percent. The current rate of interest for bonds with Submarine Sandwich's rating is 10 percent per
year. The bonds pay annual interest.

c. The preferred stock currently sells at its par value of $100 per share.

d. There are 10 million shares outstanding and the stock currently sells at $24 per share.

The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2016
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In addition, Hansen had discussions with several investment bankers and security analysts for major
brokerage firms to learn something about investor expectations for the company and the costs that
would be incurred by the firm if it attempted to obtain additional outside capital. Hansen received the
impression from the security analysts that investors do not expect Submarine Sandwich to continue to
enjoy the same rate of growth it has had for the past ten years. In fact, most of the analysts seem to be
estimating the company's future growth to be only one half the rate experienced during the last decade.

The analysts, however, do expect the firm to continue paying out about 60 percent of the earnings
available to common in the form of cash dividends. At the last annual meeting, Walker had in fact
announced that the policy of paying out at least 60 percent of earnings would be maintained. Walker
also stated that if expansion needs did not meet the required 40 percent retention rate, the payout ratio
would be increased.

After a careful analysis of the existing financial structure, Hansen determined that the mix of debt,
common stock, and preferred stock that was optimum (that is, produced the lowest average cost-of-
capital) was the one that the company presently employed. The proportions of this mix had been
relatively stable over the past five years, and they were used to construct the projected December 31,
2001 balance sheet.

Table 2 Sales and Earnings

Sales Earnings After Taxes Earnings per Share
Year Available to Common
(Millions of Dollars) of Common Stock
Stock (millions of dollars)
2001 $ 1,152 $31.25 $3.13
2000 959 28.80 2.88
1999 848 25.40 2.54
1998 800 24.88 2.49
1997 716 21.46 2.15
1996 668 20.04 2.00
1995 608 18.24 1.82
1994 560 16.80 1.68
1993 524 15.77 1.58
1992 476 14.76 1.48
1991 413 12.10 1.21
Note: a. The firm's marginal tax rate is 48 percent.

Hansen also asked the investment banks and Submarine Sandwich 's commercial bankers what the firm's
cost of various types of capital would be, assuming that the present capital structure is maintained. His
study yielded the following conclusions.

Debt
Up to and including $4 million of new debt, the company can use loans and commercial paper, both of
which currently have an interest rate of 10 percent.

The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2016
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From $4.01 to $10 million of new debt, the company can issue mortgage bonds with an Aa rating and an
interest cost to the company of 12 percent on this increment of debt.

From $10 to $14 million of new debt, the company can issue subordinated debentures with a Baa rating
that would carry an interest rate of 13 percent on this increment of debt.

Over $14 million of new debt would require the company to issue subordinated convertible debentures.
The after-tax cost of these convertibles to the company is estimated to be 11 percent on this increment
of debt.

Preferred Stock

The company's preferred stock, which has no maturity since it is a perpetual issue, pays a $9 annual
dividend on its $100 par value and is currently selling at par. Additional preferred stock in the amount of
$2 million can be sold to provide investors with the same yield as is available on the current preferred
stock, but flotation costs would amount to $4 per share. If the company were to sell a preferred stock
issue paying a $9 annual dividend, investors would pay $I00 per share, the flotation costs would be $4
per share, and the company would net $96 per share.

From $2.1 to $3.0 million of preferred stock, the after-tax, after-flotation cost would be 10.5 percent for
this increment of preferred stock.

For over $3 million of preferred stock, the after-tax, after-flotation cost would be 13 percent for this
increment.

Common Stock

Up to $2.5 million of new common can be sold at the current market price, $24 per share, less a $3 per
share flotation cost. Over $2.5 million of new common stock can be sold at $24 per share, less a $5 per
share flotation cost.

President Walker asked Hansen to estimate the company's investment opportunity schedule and to
superimpose this schedule on the cost-of-capital schedule to give the board of directors an idea of the
amount of funds likely to be required during the 2002 budget year. After thinking about how he would
develop the investment opportunity schedule, Hansen concluded that the best approach would be to
ask the operating officers to estimate the number and total cost-of-capital projects that would have
positive net present values at various cost-of-capital hurdle rates. However, given the current state of
knowledge in the company, Hansen recognized that it would be impossible for the division heads and
district managers to respond meaningfully to this request.

Hansen therefore went to each operating manager and explained what he wanted to accomplish. Each
manager indicated to Hansen the major projects under consideration by the division or district and the
estimated costs and cash flows that would result if these projects were implemented. Hansen also
requested information on minor projects (relatively small replacement decisions and the like) and
concluded that their total was so small that they could be ignored without seriously affecting his results.
The major projects, together with their costs and estimated annual cash flows, are shown in Table 3.
Note that the projects are not divisible; each must be accepted or rejected in its entirety.

The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2016
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Table 3 Investment Opportunities (Millions of Dollars)

Estimated Estimated
Project Cost of Estimated Life Internal Rate of
Annual Cash
Identification Project (Years) Return on
Inflows
Project
A $ 7.0 $1. 03 15 12%
B 4.0 0.81 9
C 5.0 1.05 6 7%
D 10.0 1.54 12
E 9.0 2.00 10 18%
F 3.0 0.60 10 15 %
G 4.0 0.95 5 6%
H 6.0 1.13 8

Note: These projects arc indivisible in the sense that each must be accepted or rejected in its entirety;
that is, no partial projects may be taken on to investigate only major projects, on a case study
basis, and to do this in face-to-face meetings with each division manager.

To aid Hansen in preparing his report, you are asked to answer the following questions.

QUESTIONS

1.Determine Submarine Sandwich's existing market value capital structure. Disregard the minor amount
of accounts payable, which constitutes “free” capital. Also, lump notes payable in with long-term
debt. Round to the nearest percent.

2. If Submarine Sandwich maintains this optimum market value capital structure, calculate the breaking
points in the MCC schedule. Recall that the company is projecting $31.25 million of earnings available
to common and a 60 percent dividend payout ratio.

3. Now calculate MCC = Ka in the interval between each of the breaking points, and graph the MCC
schedule in its step-function form. In your calculations, use 60 percent of estimated 2001 earnings
per share as your value of D1, and use the current price as Po. To reduce the calculations, you may
take as given ka = 9.4 percent in the first interval, K a = 9.9 percent in the second interval, and K a = 13.2
percent in the last interval. (Note: the marginal tax rate is 48 percent.)

4.Estimate to the closest whole percentage point the missing internal rates of return in Table 3 and then
use the information developed thus far in the case to decide which projects should be accepted.
Illustrate your solution technique with a graph and conclude your answer to this question with a
discussion of the accept-reject decision on the marginal project.

5. Note that all of your calculations are done as of the summer of 2001; yet, actions such as selling
securities and investing in assets will occur during 2002. What would happen if (a) more or fewer
"good" projects are actually available than Hansen now anticipates, or (b) conditions in the capital
markets change so as to raise or lower the MCC curve? How should the company react to such
changes? That is, what instructions should corporate headquarters issue to the operating personnel
charged with acquiring assets if and when actual conditions differ from those

The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2016
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expected during the budgeting period?

6. Do you think Hansen is likely to be more confident about his ex ante (or estimated) MCC or his ex
ante IOS schedule? Explain.

7. Have you made any implicit assumptions in your analysis to this point about the riskiness of the
various projects compared to: (a) each other, and (b) the firm's existing assets? If these assumptions
are not valid, can you indicate how the analysis could be modified?

8. Depreciation has not been considered explicitly in the case. Suppose you were informed that the
company is expected to generate cash flows from depreciation in the amount of $20 million during
2002. How would this affect your analysis?

9. The case indicated that "free capital" could be ignored. Suppose the company actually had a large
amount of accruals, accounts payable, and accrued taxes, and Submarine Sandwich anticipated a
substantial increase in these items during 2002. How would this affect your analysis?

10. In the MCC calculations, no distinction was made between short-term notes payable and long-term
debt. Is this treatment appropriate? If not, how should short-term debt be treated?

11. Suppose you learned that members of the Grabowski family controlled a large amount of the firm's
stock (60 percent) and also were in the highest tax bracket (state plus federal) for dividends. How
might this influence the analysis?

12. Use the CAPM equation to determine Submarine Sandwich 's cost-of-equity at its existing capital
structure. Assume that the firm's beta coefficient is 1.2, the risk-free rate is 7.5 percent, and the
average market return is 12.3 percent. How does this value compare with your calculations in
Question 3? Which, if either, do you believe to be more n early correct? Why?

The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2016