Capital Budgeting Case Citrus Roots Company is a leading producer of fresh, frozen, and made-from-concentrate citrus drinks. The firm was founded in 1922 by Matthew Davis, an army veteran who settled in Miami after World War I and began selling real estate. Since real estate sales were booming, Daviss fortunes soared. 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. Originally, Davis sold his oranges, lemons, and grapefruit to wholesalers for distribution to grocery stores. However, in 1959, when frozen juice sales were causing the industry to boom, he joined with several other growers to form Citrus Roots Company, which processed its own juices. Today, its Citrus Roots, Florida Gold, and Citrus Sunrise brands are sold throughout the United States. Citrus Roots management is currently evaluating a new productlight orange juice. Studies done by the firms 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 offers35% less calories. Aurelia Johnson and Sean OMalley, 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 companys executive committee. Production facilities for the light orange juice product would be set up in an unused section of Citrus Roots 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 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 Roots plant would total $20,000, and installation charges would add another $50,000 to the total equipment cost. Further, Citrus Roots 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 Roots spent $100,000 to rehabilitate that section of the plant. Sean 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 Roots 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 2 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, Aurelia Johnson noted a short memo from Citrus Roots 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. Aurelia 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 Roots federal-plus-state tax rate is 40%, and with a 10% cost of debt and a 14% cost of equity, its overall cost of capital is 10%, calculated as follows: WACC = 0.5(10%)(1-0.4) + 0.5(14%) = 10.0%. Aurelia and Sean 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 Roots executive committee. The second capital budgeting decision which Aurelia and Sean 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 Roots 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.

Expected Net Cash Flows Project S Project L Year 0 -110,000 -110,000 Year 1 70,000 37,000 Year 2 70,000 37,000 Year 3 0 37,000 Year 4 0 37,000 Answer the following questions 1. What is capital budgeting? 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. Using Excel, develop the Base Case: 6. What is the NPV, IRR, MIRR and payback period. Show your work. 7. Should the project be undertaken based on the most appropriate decision rule? 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. 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? 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? 10. The second capital budgeting decision which Aurelia and Sean 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 Root'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% corporate cost of capital. What is each project's equivalent annual annuity? Which project should be chosen and why? Expected Net Cash Flows Project S Project L Year 0 -110,000 -110,000 Year 1 70,000 37,000 Year 2 70,000 37,000 Year 3 0 37,000 Year 4 0 37,000