CASE STUDY IN CAPITAL BUDGETING "Orange Gold" company is a leading producer of fresh, frozen, and made-from concentrate, orange juice and drinks. The firm was founded in 1990 by Jim Phillips who was a successful farmer in Florida. At the beginning of his career, Jim was selling his produce to local grocery stores but later he expanded to the making of orange juice which was distributed throughout the States. The management of the firm is currently evaluating a new product - the light orange juice. After spending $183,000 in R&D and $38,000 in marketing research, the firm found that there is a significant number of potential customers that although like the taste of orange, do not consume much of its juice because of its high concentration in glycose. The marketing consultant is very optimistic about the project and he believes that it will be a great success. He has received a fee of $60,000 which is non-refundable. The new product although more expensive than the existing competing brands contains 35% less glycose with no added sugar. You are working in the finance department and you are asked to analyze this project, along with two other potential investments, and then present these findings to the company's executive committee chaired by Jim Phillips himself. Production facilities for the new product would be set up in an unused section of the company's main production premises. This part of the plant was built twenty years ago and the firm could earn a rental income from it around $120,000 per year. That section of the plant where the production of the new product would occur has been unused for several years, and consequently it has suffered some structural damage. Last year, as part of a routine facilities improvement program, the company had spent $62,000 to restore that section of the plant but an extra $50,000 cost will be needed if it is used for the particular project. Relatively inexpensive, used machinery with an estimated cost of $680,000 would be purchased, but shipping costs to move the machinery to company's plant would total $32,000, and installation charges would add another $55,000. Further inventories (raw materials, work-in-process, and finished goods) would have to be increased by $323,000 at the time of the initial investment while the extra credit from suppliers tied to this project will be $160,000. The investment cost includes the cost of machinery, shipping and installation and will be depreciated over 5 years with a residual value of 60,000. The management of the firm believes to sell 500,000 cartons of the new orange juice product in the first year expecting to increase to 620,000 for the remaining 4 years. The price will be $4.50 per carton, for the first year as part of a promotional campaign, and then the price will be $5.20 for the subsequent years. $1.80 per carton would be needed to cover the variable costs. The annual incremental fixed costs for the new plant will be 180,000. The firm used to pay $54,500 per year for insurance but with the new project the total insurance cost for the company will rise to $88,600 per year. Moreover, you have been informed that all companies in the industry have to provide training to their employees on food safety at a cost of $58,000 per year. In examining the sales figures, you noted a short memo from the sales manager, Judy Shelton, expressing her concerns that the new product would cut the volume of the firm's classic orange juice. The company last year sold 900,000 cartons of classic orange juice. If, however, the new product is introduced the annual sales might drop by 20%. The classic orange juice has a stable price of $3.9 per carton. The variable cost per carton of classic orange juice is $0.5. The company has a WACC of 16%. The tax rate of the firm is 20%. (All calculations should be rounded to two decimals).

QUESTIONS

1. Suppose another juice producer had expressed an interest in leasing the production site for $100,000 a year. If this were true, how would you treat this information?

2. What is the project's NPV, and payback period for the 5 year period of the new product?

3. What other qualitative factors you should consider before taking your final decision?