Enterprise Deauville, S.A. (ED), develops, processes, and sells a broad line of animal feedstuffs--substantially all of which are derived from corn, soybeans, sugar beets, and other agricultural commodities. In the spring of 2020, M. Rene LeBlanc, the companys Director of Finances, was reviewing the capital budget for one of the companys divisions for the fiscal year beginning 1 July. Senior management of the company had established a budget of 20 million Euros for the division for the year, although one required expenditure for the expansion of the divisions waste processing facilities was to be considered outside the budget. That investment was mandatory for the firm to undertake in order to comply with recent environmental legislation. It therefore was not subject to the expenditure limitations on other projects.

M. LeBlanc had joined the company in 2013, at a time when ED was using an internal-rate-of-return procedure for analyzing investments. This procedure was thought by many in the firm to be questionable in concept, particularly in the context of the firms rapid expansion under conditions of capital rationing. Based on his education at a renowned graduate business school, M. LeBlanc successively advocated conversion to a net present value (NPV) approach to decision-making. Shortly thereafter, he was promoted to his present position. Although the necessary NPV calculations for most of the proposed investment projects under consideration by the division had been completed, M. LeBlanc faced the problem of analyzing the soybean processing facilities at the firms Dieppe plant, as well as having to decide between two alternatives for the plants waste treatment operations. The soybean processing operation had been constructed in 2005, and needed a major overhaul and renovation if it were to continue to operate. Annual cash operating profits, before depreciation and taxes, had been running at a rate of 2.6 million Euros but, without an overhaul in the near future, would cease since the equipment involved was in an advanced state of deterioration. Certain portions of the equipment, however, could be sold if the operation were terminated (see below). All the equipment was fully depreciated to zero book value. The overhaul program would require an initial capital outlay of 6 million Euros. Those expenditures would be depreciated to zero over a ten-year period. Originally, it had appeared that an additional 2 million investment would be needed for stainless steel soaking tanks as well (also depreciable over ten years), but the plant engineer had recently discovered that some idle corn soaking tanks were available that could be used instead. These had already been depreciated to a book value of 1 million and had five years of depreciable life remaining, on a straightline amortization schedule. The tanks would be depreciated to zero over the five years if they were retained for use in the plant. Since the tanks were about to be sold for only 200,000 the plant engineer was happy to find an alternative use for them so as not to absorb the loss that would be recorded if they were sold. The expected physical life of these tanks was at least another 12 years. Approximately 1.68 million of working capital was presently tied up in the soybean processing operation. That investment would have to be maintained if production were to continue.

M. LeBlancs investigation of the project turned up some additional good news and bad news. In the former category, the overhaul involved the installation of certain new equipment which was more compact than the existing machinery, even though it would have the same productive capacity. As a result, 200 square meters of floor space in the plant would be freed up. Because facilities fixed overhead (mainly plant depreciation and property taxes) was allocated to the various operations in the plant at a rate of 600 per square meter per year, this reduction in space utilization would diminish the burden of the soybean operations, and thereby improve its reported profitability. As to the bad news, continuation of production would require the replacement of a byproducts incinerator at an earlier date than if the operations were eliminated. Originally scheduled for replacement in eight years (mid-2028) at an anticipated cost of 2 million, that date would have to be moved up by three years (to mid-2025) if the incinerator had to handle soybean processing byproducts as well as other byproducts. The replacement cost, on the other hand, was expected to be just 1.8 million in 2025 because certain price increases would most likely not yet have taken place. Whenever the incinerator was replaced, it could be depreciated fully for tax purposes over a four-year period--although it would last virtually indefinitely with proper maintenance. A market for the items produced by the soy processing operation was expected to exist for 12 more years. The proposed overhaul would permit production to extend over that period, and would allow the present level of 2.6 million of operating profits to be maintained. After 12 years, the operation would be terminated. The salvage value of the production equipment was estimated to be 500,000 at the end of 12 years. If the operation were terminated in 2020, production would be stopped on 1 July. The existing soybean processing equipment, excluding the soaking tanks, could be disposed of then. This equipment would bring 3 million on the secondhand market. While the 200 square meters of space that would be freed up if operations were to continue with more compact equipment had no real alternative use by ED, if operations were terminated a total of 800 square meters of space would become available for use. The firm did have an alternative use for that space. Specifically, the firm could use the area for storage, and it could thereby save an annual rental of 90,000 which it was now paying for other storage facilities. The next rental payment was due on 1 July. Overhead expenses would of course continue to be charged on the space. The other investment projects which were under consideration by M. LeBlanc for the coming budget year had the following characteristics:

Outlay Gross Present Net Present Project Required Value Value A 4.0 million 7.6 million 3.6 million B 2.0 million 5.0 million 3.0 million C 10.0 million 14.0 million 4.0 million D 8.0 million 9.0 million 1.0 million E 12.0 million 16.0 million 4.0 million

where the figures labeled Gross Present Value represent the present value of all the future cash flows of the projects after the initial investment expenditure. Thus, the net present value figures are the difference between these future cash flow values and the initial investment. Projects A and B listed were mutually exclusive projects. The firm could choose only one of these, whatever other projects it chose. While senior management had imposed a 20 million limit on the divisions expenditures for these projects, approval had additionally been given outside that budget for an improvement in EDs waste treatment facilities, as required by legislation. One of the possible choices was the installation of a new technology produced in Germany. This equipment would cost 600,000 and would be depreciable over five years. Annual pre-tax operating costs would amount to 50,000. The equipment would last physically seven years, at which time it would have to be replaced. It would have no salvage value. In addition, at the end of the third year of its operation, an overhaul costing 200,000 would be required. That expenditure could be immediately expensed for tax purposes, rather than having to be depreciated. The alternative choice was a Belgian system. It was less expensive to install, but it also would become increasingly more costly to maintain and operate over time. An initial outlay of 300,000 would be needed for it. The equipment would last for seven years, although its depreciable life for tax purposes was just three years. No salvage value was forecast for it. Operating costs would be as follows:

Year Amount 1 60,000 2 80,000 3 100,000 4 120,000 5 150,000 6 220,000 7 260,000 __________________ all of which are before taxes. If the Belgian system were adopted, a supplemental concrete settling tank would also have to be installed. This tank would cost 270,000 and could be depreciated over ten years. Because of its great durability, however, it would last virtually indefinitely without having to be replaced. M. LeBlanc had estimated that EDs cost of capital (required return on investment) was 10 percent per annum, after taxes. He had used this figure to compute the present values of projects A through E listed above. The firm was expected to be in a 40 percent marginal tax bracket, for both regular income and capital gains and losses. A straight-line depreciation schedule was used for tax purposes for all assets.

ASSIGNMENT: 1. Analyze the decision to overhaul the soybean processing operation. State, in quantitative terms, the difference between overhauling the operation and selling off the marketable equipment. Make a recommendation as to which alternative creates more value for the firm. 2. Make a recommendation as to which of the proposed projects EDs division should spend its 20M Euro budget on for the coming year. (i.e. spend the 6M Euros to overhaul the soybean processing operation and then take some of the projects A-E, only take some projects A-E, sell off soybean processing 5 equipment and take some of projects A-E, etc. In other words, which combination maximizes the value to the firm?) 3. Which of the two waste-treatment alternatives should be chosen--the German or the Belgian system? Note that these are not equally-lived projects.