1. BACKGROUND To promote agricultural development, the government has introduced several incentives aimed at promoting agricultural trade. These incentives, among other things, include tractor and equipment subsidies, significantly reduced municipality tariffs and skills transfer programmes. The Plaatje family intends to pursue opportunities relating to these incentives. The Plaatje family owns a 25-hectare piece of prime land in the Klein Karoo region that is considered suitable for both agricultural and residential purposes. Currently, only 2-hectaresof the land is used, primarily for residential purposes. The Plaatje family has decided to make productive use of the land and would like to establish a wine and juice making group, the Plaatje Group. The group will comprise of two major operating companies: Plaatje Winery and Plaatje Bottling. The Plaatje family has also consulted with Mkhize Business Consultants (MBC), a leading business consulting firm, to assist with its business case. This wine and juice making venture will operate for the next 15 years after which the Plaatje family will wind up the operations. Companies within the Plaatje Group will adopt the absorption costing method of Cost Accounting and the first-in-first-out (FIFO) inventory valuation method. 2. EXTRACT FROM THE BUSINESS CASE FOR PLAATJE WINERY Plaatje Winery, whose operation is planned to consist of a vineyard, where white grapes will be harvested, as well as wine cellars and juice tanks. The white grapes will be processed and fermented to produce semi-sweet white wine and white grape juice. In each financial year, Plaatje Winery will have one harvest period with an expected average yield of 600 tonnes of white grapes. The process of wine and juice making will include costs relating to, amongst others, soil preparation, seeds, seed planting , irrigation, pest control, farm labour, harvesting and quality inspection. These costs are to be incurred prior to the quality inspection phase (the grading process after harvest), where grapes are separated into the following three grades.(i) Grade A (80% of the harvest); (ii) Grade B (16% of the harvest) and (iii) Grade C (4% of the harvest). Only Grade A grapes will be fermented to produce the semi-sweet white wine. Grade B grapes will be processed further to make grape juice, cellulose and other organic compounds are added to the grape juice to give it a rich and natural taste. The annual production is expected to match the annual demand of 304 000 litres of semi-sweet white wine and 152 000 litres of white grape juice. Grade C is of such poor quality that it is sold at R4,50 per kilogram to pig farmers who use it to supplement their pig feed. 3. IRRIGATION COST ESTIMATION FOR PLAATJE WINERY Plaatje Winery needs a steady water supply for the irrigation of the vineyard and for the processing of wines and juices. The water is also needed for general operations and residential purposes. Plaatje Winery is exploring the most cost-effective option for its water supply requirements, considering the recent unstable water supply in the country. In this regard, two options (municipality supplied water or borehole supplied water) are available to meet the expected monthly average water requirements of 11 500 kilolitres. To set up the irrigation system to cover the entire farm, the associated costs are expected to be R187 000, once-off payable upfront regardless of the option chosen. The water usage is not expected to vary significantly over the years as there is no intention to increase the amount of land to be used for growing the grapes. 3.1 MUNICIPALITY SUPPLIED WATER Upon inquiry from Wessel Wines, a similar nearby winery, Plaatje Winery was able to obtain Wessel Wines municipal invoices as shown below. If the municipality supplied water option is selected, Plaatje Winery will use Wessel Wines municipal invoices as a base for estimating irrigation costs. However, the municipality is expected to apply a 6% annual inflationary increase on all its charges from January 2024. Using historic data from Statistics South Africa, Plaatje Winery estimated that on average this annual increase on municipal charges will continue to apply in the coming years. Wessel Wines municipal invoices reflected the following: Municipal invoice month Water consumption Total municipal charges June 2023 12 500 kilolitres R65 000 July 2023 11 280 kilolitres R59 510 August 2023 11 300 kilolitres R57 905 September 2023 12 350 kilolitres R65 560 If the municipality supplied water option is selected, at the start of the project, Plaatje Winery will have to pay a once-off water supply connection fee of R12 000 directly into Hessequa Municipalitys bank account. In addition, Wessel Wines suggested that Plaatje Winery also pay R3 000 into the municipality water supply officers personal bank account to fast track its connection to the water system. Piping costs of R38 250 will also be incurred at implementation of this project. Due to current water shortages in regions not far from Plaatje family homestead, there are concerns that the Klein Karoo region may also experience water challenges which will lead to water restrictions, especially for farmers in the region. Water restrictions have been predicted, by the municipality, to occur over the next two years. To minimise the impact of disruptions to the plant due to the water restrictions, Plaatje Winery is expected to pay independent water suppliers R52 000 at the end of Year 1 and another R57 500 at the end of Year 2 to meet any water demands that cannot be met by the municipality. 3.2 BOREHOLES SUPPLIED WATER If the borehole supplied water option is selected, Plaatje Winery will use one of the boreholes currently used for its residential needs which has 40% excess capacity. This borehole was drilled four years ago at a cost of R88 000. With this option, this borehole will then supply 40% of the water requirements of the Winery. Pumping costs will amount to R2,60 per kilolitre. Plaatje Winery will be required to drill a second borehole from which the other 60% of the water requirements will be pumped. Due to the complex geology of the site, the setup cost for this borehole is R294 000, including labour, pipes, ropes and a base plate. However, as a repeat client, Plaatje Group is entitled to a 5% discount. This borehole will be used exclusively by Plaatje Winery. New advanced drilling and pumping technology will make it possible to reduce the pumping costs for this borehole to R1,80 per kilolitre. Plaatje Winery will depreciate the boreholes at 20% per annum on a straight-line basis. The expected annual service costs will be R5 000 for the existing borehole, 70% resulting from domestic usage and 30% from business usage. For the new borehole, the annual service costs will be R3 000. The service costs are mainly driven by the level of usage of boreholes. 4. ADDITIONAL INFORMATION 4.1 In evaluating long-term projects, the Group will use the target weighted average cost of capital. It is estimated that the Groups cost of debt (D) will approximate the current prime lending rate of 10,5%; and that the cost of equity (E) will be 19,5%. The target capital structure is 50%:50% (D: E). 4.2 Plaatje Winery uses a corporate taxation rate of 27% and tax will be paid/deducted in the same period of the income/expense. Ignore the effect of VAT throughout the case study. 4.3 Capital allowance or wear and tear on farming plant and equipment is granted fully in the year the cost is incurred and paid. Plaatje Winery will have sufficient taxable income in the year that the deduction will be incurred. 4.4 For tax purposes, assume that all income and expenses relating to the winery operations are taxable and deductible on average at the same time the income is received, or expense is paid (no tax lag). 4.5 The two water supply options have been evaluated using capital budgeting techniques and the results are shown in the attached spreadsheet. LU 3 Case 3_8 September 2023 .xlsx You are required to: 1. Critique the capital budgeting calculations provided in the attached spreadsheet for each option. Your response should include: Discussion of errors made in the calculation Discussion of assumptions made in the numbers/amounts used in the calculation Impact of the above on the calculation. Do not reperform the calculations. 2. Assuming that the borehole option is considered more viable than the municipality supplied water from a quantitative perspective, discuss five relevant qualitative factors that should be considered by the company in their decision between the two water supply options. The above must be presented in a report to the board of directors of the Plaatje Group (the Group).