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 light 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 Citrus Sunshines plant would total $20,000, and installation charges would add another $50,000 to the total equipment cost. Further, Citrus Sunshines 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 light 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, Citrus Sunshine spent $100,000 to rehabilitate that section of the plant. Stewart believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the light orange juice project. His contention is that if the 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. Citrus Sunshines management expects to sell 425,000 16-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, Julia Johnson noted a short memo from Citrus Sunshines sales manager which expressed concern that the light orange juice project would cut into the firms sales of regular orange juicethis type of effect is called cannibalization. Specifically, the sales manager estimated that regular orange juice sales would fall by 5% if light orange juice were introduced. Julia Capital Budgeting Case 2 then talked to both the sales and production managers and concluded that the new project would probably lower the firms 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 -$20,000. Citrus Sunshines federal-plus-state marginal tax rate is 40%, and with a 10% cost of debt and a 14% cost of equity, its overall cost of capital is 10%. Julia and Stewart were asked to analyze this project, along with two other projects discussed below, and then to present their findings in a tutorial manner to Citrus Sunshines executive committee. The second capital budgeting decision which Julia and Stewart were asked to analyze involves choosing between two mutually exclusive projects, S and L, whose cash flows are set forth in the table below. Both of these projects are in Citrus Sunshines main line of business and have average risk, hence each is assigned the 10% corporate cost of capital. The investment, which is chosen, is expected to be repeated indefinitely into the future. Answer the following questions in tutorial fashion directed to the Executive Committee. If you use Excel for computations, make them appendices, but summarize the findings in the document.

Expected Net Cash Flows

Project S Project L

Year 0 -110,000 -110,000

Year 1 70,000 70,000

Year 2 70,000 37,000

Year 3 0 37,000

Year 4 0 37,000

1. Define the practice of capital budgeting and motivate its importance to the client.

2. 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.

3. Should the $100,000 that was spent to rehabilitate the plant be included in the analysis? Explain.

4. Suppose another citrus producer had expressed an interest in leasing the light 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?

5. Use Excel to develop the Base Case (place it in an appendix, but explain the process to the client.)

6. What is the NPV and the IRR of this project? Show your work.

7. Should the project be undertaken based on the most appropriate decision rule? Explain.

8. What is the difference between independent and mutually exclusive projects?

9. Assume that inflation is expected to average 5% per year over the next four years. a.Are the projects cash flow estimates real or nominal (are the cash flows stated in constant (year 0) dollars, or has inflation been built into the cash flows)? b.Is the 10% cost of capital a nominal or a real rate? Why? c.Is the current NPV biased, and, if so, in what direction? Explain.

10. The second capital budgeting decision which Julia and Stewart were asked to analyze involves choosing between two mutually exclusive projects, S and L, whose cash flows are set forth in the table below. Both of these projects are in Citrus Sunshines 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% corporate cost of capital. What is each projects equivalent annual annuity? Which project should be chosen and why?