Archer Wineries, Inc Archer Wineries is a leading New South Wales wine producer. The firm was founded in 1968 by Charles Archer who had spent several years in France and who was convinced that New South Wales could produce wines that were as good as or better than the best France had to offer. Originally, Archer sold his wine to wholesalers for distribution under their brand names, but in the early 1970s, when wine sales were expanding rapidly, he joined with several other producers to form Archer Wineries, which then began an aggressive promotion campaign. Today, its wines are sold throughout world. Archer's management is currently evaluating a potential new product; a light, fruity wine designed to appeal to the younger generation. The new product, Wine Gold, would be positioned between the various wine coolers and the traditional wines. The new product would cost more than wine coolers, but less than premium table wine, and in market research samplings at the company's headquarters, it was judged superior to various competing products. Jan Armstrong, the Chief Financial Officer, must analyse this project, along with other potential investments, and then present her findings to the company's executive committee. Production facilities for the new wine product would be set up in an unused section of Archer's main plant. Relatively inexpensive, used machinery with an estimated cost of only $500,000 would be purchased, but shipping costs to move the machinery to Archer's plant would total $40,000, and installation charges would add another $60,000 to the total equipment cost. Further, Archer's inventories (the new product requires some aging at the winery) would have to be increased by $20,000, and this cash flow is assumed to occur at the time of the initial investment. The machinery has a remaining economic life of 4 years and the Inland Revenue ruling will allow Archer Wineries to claim the following annual depreciation allowances: The machinery is expected to have a salvage value of $50,000 after 4 years of use. The section of the plant in which production would occur has not been used for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, Archer spent $200,000 to rehabilitate that section of the main plant. Ian Smith, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the wine project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $200,000 to make the site suitable for the wine project. Archer's management expects to sell 200,000 bottles of the new wine product in each of the next 4 years, at a wholesale price of $4 per bottle, but $3 per bottle would be needed to cover fixed and variable cash operating costs. In examining the sales figures, Armstrong noted a short memo from Archer's sales manager which expressed concern that the wine project would cut into the firm's sales of wine coolers - this type of effect is called an externality (or opportunity cost). Specifically, the sales manager estimated that wine cooler sales would fall by 5 percent if the new wine were introduced. Armstrong then talked to both the sales and production managers, and she concluded that the new project would probably lower the firm's wine cooler sales by $40,000 per year, but, at the same time, it would also reduce production costs for this product by $20,000 per year, all on a pre-tax basis. Thus, the net externality effect would be $40,000+$20,000=$20,000. Archer's effective tax rate is 40 percent, and its overall cost of capital is 10 percent. Now assume that you are Armstrong's assistant and she has asked you to analyse the project and then to present your findings in a 'tutorial' manner to Archer's executive committee. As Chief Financial Officer, Armstrong wants 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 her capital budgeting decisions. Therefore, Armstrong wants you to ask and then answer a series of questions as set out below. Specifics on the other two projects that must be analysed are provided in Questions 4 and 5. Keep in mind that you will be questioned closely during your presentation, so you should understand every step of the analysis, including any assumptions and weaknesses that may be lurking in the background and that someone might spring on you in the meeting. discount rate to use when evaluating this project Question 1 (10 marks) a. 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. b. Should the $200,000 that was spent to rehabilitate the plant be included in the analysis? Explain. c. Suppose another wine maker had expressed an interest in leasing the wine production site for $10,000 a year. If this were true (in fact it was not), how should that information be incorporated into the analysis? Question 2 (15 marks) Complete Tables 1 and 2 and determine the cash flows for the projects. Question 3 (15 marks) Using the relevant cash flows identified in Tables 1 and 2, calculate the projects: a. Net Present Value (NPV) b. Internal Rate of Return (IRR) c. Payback Period d. Will you recommend that the project should be undertaken? Why or why not? Question 4 (10 marks) The second capital budgeting decision which Armstrong and you were asked to analyse involves choosing between two mutually exclusive projects, S and L, whose cash flows are set forth below: Both of these projects are in Archer's main line of business, premium table wine, and the investment which is chosen is expected to be repeated indefinitely into the future. Also, each project is of average risk, and hence each is assigned the 10% required rate of return. What is each project's single cycle NPV? Can you make a decision on this information? Why or why not? If not, what should you do to be able to make a decision? Which project should be chosen? Why? Question 4 (10 marks) The third decision to be considered involves a fleet of trucks with an engineering life of three years (that is, the trucks 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 a positive salvage value. Here are the estimated net cash flows for each truck: The relevant required rate of return is again 10%. What would the NPV be if the trucks were operated for the full three years? What if they were abandoned at the end of Year 2 ? What if they were abandoned at the end of Year 1 ? What is the economic life of the truck project? Archer Wineries, Inc Archer Wineries is a leading New South Wales wine producer. The firm was founded in 1968 by Charles Archer who had spent several years in France and who was convinced that New South Wales could produce wines that were as good as or better than the best France had to offer. Originally, Archer sold his wine to wholesalers for distribution under their brand names, but in the early 1970s, when wine sales were expanding rapidly, he joined with several other producers to form Archer Wineries, which then began an aggressive promotion campaign. Today, its wines are sold throughout world. Archer's management is currently evaluating a potential new product; a light, fruity wine designed to appeal to the younger generation. The new product, Wine Gold, would be positioned between the various wine coolers and the traditional wines. The new product would cost more than wine coolers, but less than premium table wine, and in market research samplings at the company's headquarters, it was judged superior to various competing products. Jan Armstrong, the Chief Financial Officer, must analyse this project, along with other potential investments, and then present her findings to the company's executive committee. Production facilities for the new wine product would be set up in an unused section of Archer's main plant. Relatively inexpensive, used machinery with an estimated cost of only $500,000 would be purchased, but shipping costs to move the machinery to Archer's plant would total $40,000, and installation charges would add another $60,000 to the total equipment cost. Further, Archer's inventories (the new product requires some aging at the winery) would have to be increased by $20,000, and this cash flow is assumed to occur at the time of the initial investment. The machinery has a remaining economic life of 4 years and the Inland Revenue ruling will allow Archer Wineries to claim the following annual depreciation allowances: The machinery is expected to have a salvage value of $50,000 after 4 years of use. The section of the plant in which production would occur has not been used for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, Archer spent $200,000 to rehabilitate that section of the main plant. Ian Smith, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the wine project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $200,000 to make the site suitable for the wine project. Archer's management expects to sell 200,000 bottles of the new wine product in each of the next 4 years, at a wholesale price of $4 per bottle, but $3 per bottle would be needed to cover fixed and variable cash operating costs. In examining the sales figures, Armstrong noted a short memo from Archer's sales manager which expressed concern that the wine project would cut into the firm's sales of wine coolers - this type of effect is called an externality (or opportunity cost). Specifically, the sales manager estimated that wine cooler sales would fall by 5 percent if the new wine were introduced. Armstrong then talked to both the sales and production managers, and she concluded that the new project would probably lower the firm's wine cooler sales by $40,000 per year, but, at the same time, it would also reduce production costs for this product by $20,000 per year, all on a pre-tax basis. Thus, the net externality effect would be $40,000+$20,000=$20,000. Archer's effective tax rate is 40 percent, and its overall cost of capital is 10 percent. Now assume that you are Armstrong's assistant and she has asked you to analyse the project and then to present your findings in a 'tutorial' manner to Archer's executive committee. As Chief Financial Officer, Armstrong wants 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 her capital budgeting decisions. Therefore, Armstrong wants you to ask and then answer a series of questions as set out below. Specifics on the other two projects that must be analysed are provided in Questions 4 and 5. Keep in mind that you will be questioned closely during your presentation, so you should understand every step of the analysis, including any assumptions and weaknesses that may be lurking in the background and that someone might spring on you in the meeting. discount rate to use when evaluating this project Question 1 (10 marks) a. 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. b. Should the $200,000 that was spent to rehabilitate the plant be included in the analysis? Explain. c. Suppose another wine maker had expressed an interest in leasing the wine production site for $10,000 a year. If this were true (in fact it was not), how should that information be incorporated into the analysis? Question 2 (15 marks) Complete Tables 1 and 2 and determine the cash flows for the projects. Question 3 (15 marks) Using the relevant cash flows identified in Tables 1 and 2, calculate the projects: a. Net Present Value (NPV) b. Internal Rate of Return (IRR) c. Payback Period d. Will you recommend that the project should be undertaken? Why or why not? Question 4 (10 marks) The second capital budgeting decision which Armstrong and you were asked to analyse involves choosing between two mutually exclusive projects, S and L, whose cash flows are set forth below: Both of these projects are in Archer's main line of business, premium table wine, and the investment which is chosen is expected to be repeated indefinitely into the future. Also, each project is of average risk, and hence each is assigned the 10% required rate of return. What is each project's single cycle NPV? Can you make a decision on this information? Why or why not? If not, what should you do to be able to make a decision? Which project should be chosen? Why? Question 4 (10 marks) The third decision to be considered involves a fleet of trucks with an engineering life of three years (that is, the trucks 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 a positive salvage value. Here are the estimated net cash flows for each truck: The relevant required rate of return is again 10%. What would the NPV be if the trucks were operated for the full three years? What if they were abandoned at the end of Year 2 ? What if they were abandoned at the end of Year 1 ? What is the economic life of the truck project