Case 1

Robert Montoya, Inc., is a leading producer of wine in the United States. The firm was founded in 1950 by Robert Montoya, an Air Force veteran who had spent several years in France both before and after World War II. This experience convinced him that California could produce wines that were as good as or better than the best France had to offer. Originally, Robert Montoya sold his wine to wholesalers for distribution under their own brand names. Then in the early 1950s, when wine sales were expanding rapidly, he joined with his brother Marshall and several other producers to form Robert Montoya, Inc., which then began an aggressive promotion campaign. Today, its wines are sold throughout the world.

The table wine market has matured and Robert Montoya's wine cooler sales have been steadily decreasing. Consequently, to increase winery sales, management is currently considering a potential new product: a premium varietal red wine using the cabernet sauvignon grape. The new wine is designed to appeal to middle-to-upper-income professionals. The new product, Suav Mauv, would be positioned between the traditional table wines and super premium table wines. In market research samplings at the company's Napa Valley headquarters, it was judged superior to various competing products. Sarah Sharpe, the financial vice president, must analyze this project, along with two other potential investments, and then present her findings to the company's executive committee. Production facilities for the new wine would be set up in an unused section of Robert Montoya's main plant. New machinery with an estimated cost of $1,800,000 would be purchased, but shipping costs to move the machinery to Robert Montoya's plant would total $80,000, and installation charges would add another $120,000 to the total equipment cost. Furthermore, Robert Montoya's inventories (the new product requires aging for 5 years in oak barrels made in France) would have to be increased by $100,000. 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 company has obtained a special tax ruling that allows it to depreciate the equipment under the MACRS 3-year class life. 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 $200,000 after 4 years of use.

The section of the plant in which production would occur had not been used for several years and, consequently, had suffered some deterioration. Last year, as part of a routine facilities improvement program, $300,000 was spent to rehabilitate that section of the main plant. Earnie Jones, 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 $300,000 to make the plant suitable for the wine project.

Robert Montoya's management expects to sell 100,000 bottles of the new wine in each of the next 4 years, at a wholesale price of $50 per bottle, but $30 per bottle would be needed to cover cash operating costs. In examining the sales figures, Sharpe noted a short memo from Robert Montoya's sales manager which expressed concern that the wine project would cut into the firm's sales of other wines?this type of effect is called cannibalization. Specifically, the sales manager estimated that existing wine sales would fall by 5 percent if the new wine were introduced. Sharpe then talked to both the sales and production managers and concluded that the new project would probably lower the firm's existing wine sales by $60,000 per year, but, at the same time, it would also reduce production costs by $40,000 per year, all on a pre-tax basis. Thus, the net externality effect would be -$60,000 + $40,000 = -$20,000. Robert Montoya's federal-plus-state tax rate is 40 percent, and its overall cost of capital is 10 percent, calculated as follows:

WACC = Wdkd (1 - T) + Wsks = 0.5(10%)(0.6) + 0.5(14%) = 10%.

Now assume that you are Sharpe's assistant and she has asked you to analyze this project, along with two other projects, and then to present your findings in a "tutorial" manner to Robert Montoya's executive committee. As financial vice president, Sharpe 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 capital budgeting decisions. Therefore, Sharpe wants you to ask and then answer a series of questions as set forth next. 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.

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 $300,000 that was spent to rehabilitate the plant be included in the analysis? Explain.

3. Suppose another winemaker had expressed an interest in leasing the wine production site for $30,000 a year. If this were true (in fact it was not), how would that information be incorporated into the analysis?

4. What is Robert Montoya'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.)

Table 1

MACRSDepr.End-of-year

YearFactorExpenseBook Value

133%$660,000$1,340,000

2XXX

3XXX

47140,0000

100%2,000,000

Cash Flow Statements:

Year 0Year 1Year 2Year 3Year 4

Unit price$50XX$50

Unit sales100,000XX100,000

Revenues5,000,000XX5,000,000

Operating costs3,000,000XX3,000,000

Depreciation660,000XX140,000

Other project effects20,000XX20,000

Before tax income1,320,000XX1,840,000

Taxes528,000XX736,000

Net income792,000XX1,104,000

Plus depreciation660,000XX140,000

Net op cash flow1,452,000XX1,244,000

Salvage value200,000

SV taxX

Recovery of NWCX

Termination CFX

Project NCF($-2,100,000)XXXX

=============

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 under-taken? [Remember: The MIRR is found in three steps: (1) compound all cash inflows for-ward 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 pre-sent 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.

Case 2:

During the depression of the 1930s, Ben Jenkins, Sr., a wealthy, expansion-oriented lumberman whose family had been in the lumber business in the southeastern United States for several generations, began to acquire small, depressed sawmills and wholesale lumber companies. These businesses prospered during World War II. After the war, Jenkins anticipated that the demand for lumber would surge, so he aggressively sought new timberlands to supply his sawmills. In 1954, all of Jenkins's companies were consolidated, along with some other independent lumber and milling companies, into a single corporation, the Georgia Atlantic Company.

By the end of 2000, Georgia Atlantic was a major force in the lumber industry, though not one of the giants. Still, it possessed more timber and timberlands in relation to its use of timber than any other lumber company. Worldwide demand for lumber was strong in spite of a soft world economy, and its timber supply should have put Georgia Atlantic in a good position. With its assured supply of pulpwood, the company could run its mills at a steady rate and, thus, at a low per-unit production cost. However, the company does not have sufficient manufacturing capacity to fully utilize its timber supplies; so it has been forced to sell raw timber to other lumber companies to generate cash flow, losing potential profits in the process.

Georgia Atlantic has enjoyed rapid growth in both sales and assets. This rapid growth has, however, caused some financial problems as indicated in Table 1. The condensed balance sheets shown in the table reveal that Georgia Atlantic's financial leverage has increased substantially in the last ten years, while the firm's liquidity position markedly deteriorated over the same period. Remember, though, that the balance sheet figures reflect historical costs, and that the market values of the assets could be much higher than the values shown on the balance sheet. For example, Georgia Atlantic purchased 10,000 acres of cut timberland in southern Georgia in 1961 for $10 per acre, and then planted trees, which are now mature. The value of this acreage and its timber is estimated at $2,750 per acre, even though it is shown on the firm's balance sheet at $230 per acre, the original $10 plus capitalized planting costs. Note also that this particular asset and others like it have produced zero accounting income; indeed, expenses associated with this acreage have produced accounting losses.