Highland Beverages Capital Budgeting Exercise

January 1^st, 2015. Highland Beverages is a soft drink manufacturing company based in Wimberley, TX, specialized in the production and distribution of all-natural fruit-flavored sparkling beverages. It is considering replacing its existing plant by a larger, more modern facility, just outside the city. Management wishes, however, to go through a proper capital budgeting exercise before making any decision.

If it decides to build the new plant, the old one will be sold at the same time that the new one begins operating in order to avoid production delays. The opening of the new plant is planned for January 1^st, 2016.

The purchase of the new plant will cost $75 Million payable at the time the plant opens. CEO Drew Crispin plans to sell the old plant for $12 Million. He already has a buyer.

The new plant will be fully depreciated over 40 years on a straight-line base basis, just like the old plant, which cost $40 Million to build and still has 12 years of economic life remaining.

Each 17-oz bottle of soft drink will be priced at $1.25 during 2015, and the price will increase by 3% per year thereafter (price increase takes effect on January 1^st, and price is rounded to the nearest cent). These projected prices will hold regardless of whether the bottles are produced in the old or in the new plant. On the other hand, the direct costs of producing each bottle (labor, raw materials, and utilities) will differ: 60% of the selling price if it is manufactured in the old plant, against 50% in the new plant.

The operating costs associated with Highlands head office in downtown Wimberley will amount to $5 million in 2015 (e.g., management salaries, marketing, selling, general and administrative expenses) and are expected to continue rising by about 2% per year, whether or not the company takes on the new project.

In addition, Highland management hired an outside consulting company to complete a feasibility study for this new project. When completed at the end of 2014, the company will pay a fee of $500,000 to the consulting company, due on January 1^st, 2016.

Below are the estimated future production amounts (in millions of bottles) in both plants for the next 5 years:

Year	2016	2017	2018	2019	2020
Old Plant	15.0	18.0	20.7	22.5	26.2
New Plant	24.0	28.7	33.5	38.5	42.3

To somewhat simplify this capital budgeting exercise, management and its outside consultants have made the following assumptions:

1. For any given year, all revenues and expenses are received or paid at the end of the year. Revenues and expenses are to be expressed in millions of $, with 2 decimals maximum (e.g., $12.52 = Twelve million, five hundred and twenty thousand dollars).

2. The old plant will be sold exactly at book value. This means that there will be no tax impact on the sale of the old plant.

3. We are considering only the next 5 years (2016-2020). Why? If management is to go ahead with the new plant, it wants the project to show positive economic value by the end of the first five years.

One of the points of discussion between management and its consultants is the choice of the discount rate for this capital budgeting exercise. It was finally decided that the discount rate would be the companys WACC.

Currently all of Highlands assets are exclusively financed by common equity and long-term debt (bonds).

The companys balance sheet shows the following values:

Bonds: $100,000,000

Common Equity:

Paid-in Capital:	$35,000,000
Retained Earnings:	$ 9,000,000

Bonds: In early January 2010, the company issued 100,000 20-year non-callable bonds with an 8% coupon paid semi-annually, at a$1,000 par value. They currently trade at $1,150. This is the only bond issue the company has made to date.

Common equity: Highland Beverages went public in 2005 and issued 1,000,000 shares at $35 each. It has not issued any new stock since then, nor has it repurchased any of its issued stock. The Highland stock currently trades at $54.

Currently, the yield on US Treasury bonds is 3.5%, and the required return for a well-diversified stock portfolio is 9%. Highland Beverages beta is estimated at 1.15.

Highland Beverages marginal tax rate is 40%.

Question

1. In this extension assume a Scenario 2. To do this extend the analysis 5 more years through 2025. At the end of 2025, assume that Highland will retire the beverage line produced at the new plant, close the new plant, and sell it at book value. Also assume that Highland decides not to sell the old plant in 2016, but rather to reuse the capacity elsewhere in its business.

2. To forecast 2021 to 2025, assume that unit sales for both the old plant and new plant increase at a constant rate of 7% per year from 2021 through 2025. All other operating assumptions remain unchanged.

3. However, Highland expects that its working capital will change as its incremental sales increase. It estimates that working capital changes will be 12% of incremental sales. It expects to be able to fully recover all incremental investments in working capital when it closes and sells the new plant in 2025.

a) Calculate the projects NPV under Scenario 2.

b) Calculate the projects IRR under Scenario 2

c) Should Highland management decide to go ahead with the new plant project under Scenario 2. Explain your answer