CASE STUDY IN CAPITAL BUDGETING "Tomato Queen" company is a leading producer of fresh, frozen, and made-from concentrate tomato juice sauces and drinks. The firm was founded in 1990 by Tim Morgan who was a successful farmer in Florida. At the beginning of his career, Tim was selling his produce to local grocery stores but later he expanded to the making of tomato juice which was distributed throughout the States. The management of the firm is currently evaluating a new product - the light tomato juice. After spending $158,000 in R&D and $37,000 in marketing research, the firm found that there is a significant number of potential customers that although like the taste of tomato, do not consume tomato juice because of its high salt and sugar content. The marketing consultant is very optimistic about the project and he believes that it will be a great success. He has received so far a fee of $70,000 of which the half is refundable in case the project is not implemented. The new product although more expensive than the existing competing brands contains 35 percent less salt and no sugar at all. 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 Tim Morgan 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 $100,000 per year but had to pay for estate management costs $8,000 per year. That section of the plant where the production of the new product would occur had 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 $42,000 to restore that section of the plant butan extra $28,000 cost will be needed if it is used for the particular project. Relatively inexpensive, used machinery with an estimated cost of $560,000 would be purchased, but shipping costs to move the machinery to company's plant would total $22,000, and installation charges would add another $55,000. Further inventories (raw materials, work-inprocess, and finished goods) would have to be increased by $123,000 at the time of the initial investment and another $80,000 in year 3. The extra credit from suppliers tied to this project will be $60,000 at the beginning of the project and further $45,000 in year 3. The machinery plus the required investment has an economic life of 4 years, and the company has obtained a special tax ruling that allows it to depreciate the equipment under the MACRS method with depreciation allowances of 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 $90,000 after 4 years use. The management of the firm believes to sell 450,000 cartons of the new tomato juice product in the first year expecting to have a compound growth rate of 20% in each of the next 3 years. The price will be $2.50 per carton, for the first year as part of a promotional campaign, and then the price will be $3.50 for the subsequent years. $1.10 per carton would be needed to cover the variable costs. The annual incremental fixed costs for the new plant will be 120,000 for the first two years and then will increase by 20% and remain at that level for the two remaining years. The firm used to pay $34,500 per year for insurance but with the new project the total insurance cost for the company will rise to $68,600 per year. You have been informed that all companies in the industry have to provide training to their employees on food safety at a cost of $38,000 per year. Moreover, all companies in the industry pay every year 1.5% of their revenues as a commission to the Food Regulatory Agency. Last year this commission was derived from the sales of the classic product only. While 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 tomato juice. The company last year sold 900,000 cartons of classic tomato juice. The particular market is a mature one and the sales growth rate has stabilized at 6% per year. If however the new product is introduced the growth rate of classic tomato juice sales will drop to half. The classic tomato juice has a stable price of $1.3 per carton. The variable cost per carton of classic tomato juice is $0.5 while the fixed production costs for the classic product are $237,000 per year and are not expected to change in the foreseeable future. The company has a pre-tax cost of debt 10% and the capital structure of the firm consist of 40% debt and 60% common equity. The tax rate of the firm is 20%. The Treasury bill is 4%, the beta of the company's stock is 2 and the Return of the market portfolio is 11%. (All calculations should be rounded to two decimals). QUESTIONS 1. Suppose another juice producer had expressed an interest in leasing the production site for $25,000 a year. If this true, how would this information be incorporated into the analysis? 2. What is the project's NPV, and payback period for the 4 year period of the new product? 3. What other factors (quantitative and qualitative) you should consider before taking your final decision? 4. Do you believe that is realistic to assume that this project will last 4 years only? Explain and state anyassumptions regarding the duration of the project.