Indian River Citrus Company (A)

Size: px

Start display at page:

Download "Indian River Citrus Company (A)"

Edith Cunningham
6 years ago
Views:

1 Case 12 Indian River Citrus Company (A) Capital Budgeting Directed Indian River Citrus Company is a leading producer of fresh, frozen, and made-from-concentrate citrus drinks. The firm was founded in 1929 by Matthew Stewart, a navy veteran who settled in Miami after World War I and began selling real estate. Since real estate sales were booming, Stewart s fortunes soared. His investment philosophy, which he proudly displayed behind his desk, was Buy land. They aren t making any more of it. He practiced what he preached, but instead of investing in residential property, which he knew was grossly overvalued, he invested most of his sales commissions in citrus land located in Florida s Indian River County. Originally, Stewart sold his oranges, lemons, and grapefruit to wholesalers for distribution to grocery stores. However, in 1965, when frozen juice sales were causing the industry to boom, he joined with several other growers to form Indian River Citrus Company, which processed its own juices. Today, its Indian River Citrus, Florida Sun, and Citrus Gold brands are sold throughout the United States. Indian River s management is currently evaluating a new product lite orange juice. Studies done by the firm s marketing department indicate that many people who like the taste of orange juice will not drink it because of its high calorie count. The new product would cost more, but it would offer consumers something that no other competing orange juice product offers 35 percent less calories. Lili Romero and Brent Gibbs, recent business school graduates who are now working at the firm as financial analysts, must analyze this project, along with two other potential investments, and then present their findings to the company s executive committee. Production facilities for the lite orange juice product would be set up in an unused section of Indian River s main plant. Although no one has expressed an interest in this portion of the plant, management wants to know how the analysis could incorporate the interest of another citrus in leasing the lite orange juice production site for $25,000 a year. Relatively inexpensive, used machinery with an estimated cost of only $500,000 would be purchased, but shipping costs to move the machinery to Indian River s plant would total $20,000, and installation charges would add another $50,000 to the total equipment cost. Further, Indian River s inventories (raw materials, work-in-process, and finished goods) would have to be increased by $10,000 at the time of the initial investment. The machinery has a remaining economic life of four years, and the company has obtained a special tax ruling that allows it to depreciate the equipment under the MACRS 3-year class. Under current tax law, the depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively. The machinery is expected to have a salvage value of $100,000 after four years of use. The section of the main plant where the lite orange juice production would occur has been unused for several years, and consequently it has suffered some deterioration. Last year, as part of a routine facilities improvement program, Indian River spent $100,000 to rehabilitate that section of the plant. Brent believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the lite orange juice project. His contention is that if the

2 rehabilitation had not taken place, the firm would have to spend the $100,000 to make the site suitable for the orange juice production line. Indian River s management expects to sell 425, ounce cartons of the new orange juice product in each of the next four years, at a price of $2.00 per carton, of which $1.50 per carton would be needed to cover fixed and variable cash operating costs. Since most of the costs are variable, the fixed and variable cost categories have been combined. Also, note that operating cost changes are a function of the number of units sold rather than unit price, so unit price changes have no effect on operating costs. In examining the sales figures, Lili Romero noted a short memo from Indian River s sales manager which expressed concern that the lite orange juice project would cut into the firm s sales of regular orange juice this type of effect is called cannibalization. Specifically, the sales manager estimated that regular orange juice sales would fall by 5 percent if lite orange juice were introduced. Lili then talked to both the sales and production managers and concluded that the new project would probably lower the firm s regular orange juice sales by $40,000 per year, but, at the same time, it would also reduce regular orange juice production costs by $20,000 per year, all on a pre-tax basis. Thus, the net cannibalization effect would be -$40,000 + $20,000 = -$20,000. Indian River s federal-plus-state tax rate is 40 percent, and with a 10 percent cost of debt and a 14 percent cost of equity, its overall cost of capital is 10 percent, calculated as follows: WACC = w d k d (1 - T) + w s k s = 0.5(10%)(1-.4) + 0.5(14%) = 10.0%. Lili and Brent were asked to analyze this project, along with two other projects discussed below, and then to present their findings in a tutorial manner to Indian River s executive committee. They were also asked to extend their original presentation to explain how inflation of 5 percent per year over the next four years would impact the analysis and how the analysis would change if the decision had been to replace an existing machine rather than to expand an existing facility. The second capital budgeting decision which Lili and Brent were asked to analyze involves choosing between two mutually exclusive projects, S and L, whose cash flows are set forth below: Expected Net Cash Flow Year Project S Project L 0 ($100,000) ($100,000) 1 60,000 33, ,000 33, , ,500 Both of these projects are in Indian River s main line of business and have average risk, hence each is assigned the 10 percent corporate cost of capital. The investment, which is chosen, is expected to be repeated indefinitely into the future. Lili and Brent are concerned about inflationary pressures. Therefore they believe it would be useful to also assume that the cost to replicate Project S in two years is estimated to be $105,000 and similar investment cost increases would occur for both projects in Year 4 and beyond. The third project to be considered involves a fleet of delivery trucks with an engineering life of three years (that is, each truck will be totally worn out after three years). However, if the trucks were taken out of service, or abandoned, prior to the end of three years, they would have positive salvage values. Here are the estimated net cash flows for each truck:

3 Year Initial Investment and Operating Cash Flow End-of-Year Net Abandonment Cash Flow 0 ($40,000) $40, ,800 24, ,000 16, ,000 0 Given the relevant cost of capital is again 10 percent, Lili and Brent have been asked to analyze the NPV over the trucks full 3 years of operation as well as earlier abandonment. The financial vice president, Lili and Brent s supervisor, wants them to educate some of the other executives, especially the marketing and sales managers, in the theory of capital budgeting so that these executives will have a better understanding of capital budgeting decisions. Therefore, Lili and Brent have decided to ask and then answer a series of questions as set forth below. QUESTIONS 1. Define the term incremental cash flow. Since the project will be financed in part by debt, should the cash flow statement include interest expenses? Explain. 2. Should the $100,000 that was spent to rehabilitate the plant be included in the analysis? Explain. 3. Suppose another citrus producer had expressed an interest in leasing the lite orange juice production site for $25,000 a year. If this were true (in fact, it was not), how would that information be incorporated into the analysis? 4. What is Indian River s Year 0 net investment outlay on this project? What is the expected nonoperating cash flow when the project is terminated at Year 4? (Hint: Use Table 1 as a guide.) 5. Estimate the project s operating cash flows. (Hint: Again use Table 1 as a guide.) What are the project s NPV, IRR, modified IRR (MIRR), and payback? Should the project be undertaken? [Remember: The MIRR is found in three steps: (1) compound all cash inflows forward to the terminal year at the cost of capital, (2) sum the compounded cash inflows to obtain the terminal value of the inflows, and (3) find the discount rate which forces the present value of the terminal value to equal the present value of the net investment outlays. This discount rate is defined as the MIRR.] 6. Now suppose the project had involved replacement rather than expansion of existing facilities. Describe briefly how the analysis would have to be changed to deal with a replacement project. 7. Assume that inflation is expected to average 5 percent per year over the next four years. a. Does it appear that the project s cash flow estimates are real or nominal? That is, are the cash flows stated in constant (current year) dollars, or has inflation been built into the cash flow estimates? (Hint: Nominal cash flows include the effects of inflation, but real cash flows do not.) b. Is the 10 percent cost of capital a nominal or a real rate? c. Is the current NPV biased, and, if so, in what direction? 8. Now assume that the sales price will increase by the 5 percent inflation rate beginning after Year 0. However, assume that cash operating costs will increase by only 2 percent annually from the initial cost estimate, because over half of the costs are fixed by long-term contracts. For simplicity, assume that no other cash flows (net externality costs, salvage value, or net working capital) are affected by inflation. What are the project s NPV, IRR, MIRR, and payback now that inflation has been taken into account? (Hint: The Year 1 cash flows, as well

4 as succeeding cash flows, must be adjusted for inflation because the original estimates are in Year 0 dollars.) 9. The second capital budgeting decision which Lili and Brent were asked to analyze involves choosing between two mutually exclusive projects, S and L, whose cash flows are set forth as follows: Expected Net Cash Flow Year Project S Project L 0 ($100,000) ($100,000) 1 60,000 33, ,000 33, , ,500 Both of these projects are in Indian River s main line of business, orange juice, and the investment, which is chosen, is expected to be repeated indefinitely into the future. Also, each project is of average risk, hence each is assigned the 10 percent corporate cost of capital. a. What is each project s single-cycle NPV? Now apply the replacement chain approach and then repeat the analysis using the equivalent annual annuity approach. Which project should be chosen, S or L? Why? b. Now assume that the cost to replicate Project S in two years is estimated to be $105,000 because of inflationary pressures. Similar investment cost increases will occur for both projects in Year 4 and beyond. How would this affect the analysis? Which project should be chosen under this assumption? 10. The third project to be considered involves a fleet of delivery trucks with an engineering life of three years (that is, each truck will be totally worn out after three years). However, if the trucks were taken out of service, or abandoned, prior to the end of three years, they would have positive salvage values. Here are the estimated net cash flows for each truck: Year Initial Investment and Operating Cash Flow End-of-Year Net Abandonment Cash Flow 0 ($40,000) $40, ,800 24, ,000 16, ,000 0 The relevant cost of capital is again 10 percent. a. What would the NPV be if the trucks were operated for the full three years? b. What if they were abandoned at the end of Year 2? What if they were abandoned at the end of Year 1? c. What is the economic life of the truck project? 11. Refer back to the original lite orange juice project. In this and the remaining questions, if you are using the spreadsheet model, quantify your answer. Otherwise, just discuss the impact of the changes. a. What would happen to the project s profitability if inflation were neutral, that is, if both sales price and cash operating costs increase by the 5 percent annual inflation rate? b. Now suppose that Indian River is unable to pass along its inflationary input cost increases to its customers. For example, assume that cash operating costs increase by the 5 percent

5 annual inflation rate, but that the sales price can be increased at only a 2 percent annual rate. What is the project s profitability under these conditions? 12. Return to the initial inflation assumptions (5 percent on price and 2 percent on cash operating costs). a. Assume that the sales quantity estimate remains at 425,000 units per year. What Year 0 unit price would the company have to set to cause the project to just break even? b. Now assume that the sales price remains at $2. What annual unit sales volume would be needed for the project to break even? TABLE 1 Project Cash Flow Estimates Net Investment Depreciation Schedule: Outlay: Price X Basis = X Freight X MACRS Deprec. End-of-Year Installation X Year Factor Expense Book Value Change in NWC X 1 33% $188,100 $381,900 X 2 X X X 3 X X X , % X Cash Flow Statements: Year 0 Year 1 Year 2 Year 3 Year 4 Unit price $ 2 X X $ 2 Unit sales 425,000 X X 425,000 Revenues $850,000 X X $850,000 Operating costs 637,500 X X 637,500 Depreciation 188,100 X X 39,900 Other project 20,000 X X 20,000 effects Before tax income $ 4,400 X X $152,600 Taxes 1,760 X X 61,040 Net income $ 2,640 X X $ 91,560 Plus depreciation 188,100 X X 39,900 Net op cash flow $190,740 X X $131,460 Salvage value $100,000 SV tax X Recovery of NWC X Termination CF X Project NCF X X X X X

Chapter 11 Cash Flow Estimation and Risk Analysis ANSWERS TO END-OF-CHAPTER QUESTIONS

Chapter 11 Cash Flow Estimation and Risk Analysis ANSWERS TO END-OF-CHAPTER QUESTIONS 11-1 a. Project cash flow, which is the relevant cash flow for project analysis, represents the actual flow of cash,