I need a help with the following

CASE STUDY IN CAPITAL BUDGETING

Orange plus company is a leading producer of fresh, frozen, and made-from- concentrate orange and lemon drinks. The firm was founded in 1990 by Jack Bealey who was a successful farmer in Florida. At the beginning of his career, Jack was selling his produce to local grocery stores but later he expanded to the making of juice which was distributed throughout the States. The orange plus management is currently evaluating a new product lite orange juice. After spending $30,000 in R&D and $23,000 in marketing research, the firm found that there is a significant part of the market that although likes the taste of orange does not consume orange juice because of its high calorie and sugar count. The new product although more expensive than the existing competing brands offers 35 percent less calories and sugar. As a recent MSc holder you are working for orange plus 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 companys executive committee chaired by Jack Bealey himself. Production facilities for the lite orange juice product would be set up in an unused section of the companys main plant. This plant was built twenty years ago and the firm could earn a rental income from it around $35,000 per year but had to pay for estate management costs $4,000 per year. The section of the main plant where the lite orange juice production 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 spent $42,000 to rehabilitate that section of the plant and additional $25,000 might be needed if the plant will be used for the particular project Relatively inexpensive, used machinery with an estimated cost of $800,000 would be purchased, but shipping costs to move the machinery to companys plant would total $20,000, and installation charges would add another $50,000 to the total equipment cost. Further orange plus inventories (raw materials, work-in-process, and finished goods) would have to be increased by $23,000 at the time of the initial investment and another $8,000 in year 3. 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 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 $110,000 after 4 years use. The management of the firm believes to sell 700,000 cartons of the new orange juice product in the first year expecting to increase by 20% in each of the next 3 years. The price will be $2.00 per carton, for the first year as part of a promotional campaign, and then the price will be $2.80 for the subsequent years. $1.50 per carton would be needed to cover incremental fixed and variable cash operating costs. Since most of the costs are variable, the fixed and variable cost categories have been combined. Also note that operating cost charges are a function of the number of units sold rather than unit price, so unit price changes have no effect on operating costs. The firm used to pay $16,500 per year for insurance but with the new project the insurance cost for the company will rise to $27,600 per year. Moreover, all companies in the industry have to provide training to their employees on food safety at a cost of $18,000 per year. In examining the sales figures, you noted a short memo from the orange plus marketing manager expressing his concerns that the lite product would cut the sales of the firms sales of the classic orange juice by 10% per year. The company currently sells 2,000,000, cartons of classic orange juice per year at a price of $1.4 each. The variable cost per carton of classic orange juice is $0,8 while the fixed production costs are $530,000 per year. The orange plus company has a cost of debt 10% and cost of equity 14% and the capital structure of the firm consist of 50% debt and 50% common equity. The tax rate of the firm is 20%.

QUESTIONS

1. Define the term incremental cash flow. Since the project will be financed in part by debt, should the cash flow analysis include the interest expense? Explain

2. Suppose another juice producer had expressed an interest in leasing the lite orange juice production site for $25,000 a year. If this true, how would this information be incorporated into the analysis?

3. What is the orange plus investment outlay on this project? What is the expected non-operating cash flow when the project is terminated at year 4?

4. Estimating the projects operating cash inflows. What is the projects NPV, payback period, and RR.

5. The project is assumed to end in year 4. Do you think that this is realistic? Can you estimate the value of the projects operating cash flows beyond year 4? State any assumptions you made.

6. Does it appear that the project cash flows are real or nominal? Is WACC of the firm real or nominal? Is the current NPV biased, and if so, in what direction?

7. What other factors (quantitative or qualitative) should management consider before taking its final decision? Explain.