In the Citrus Roots Company Case, Aurelia Johnson and Sean OMalley analyzed a light orange juice project for the Citrus Roots Company. The project required an initial investment of $570,000 in fixed assets (including shipping and installation charges), plus a $10,000 addition to net working capital. The machinery would be used for 4 years and be depreciated on the basis of a 3-year MACRS class life. The appropriate MACRS depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively, and the machinery is expected to have a salvage value of $100,000. If the project is undertaken, the firm expects to sell 425,000 cartons of light orange juice at a current dollar (Year 0) wholesale price of $2 per carton. However, the sales price will be adjusted for inflation, which the executive committee expects to average 5 percent annually, so the actual expected sales price at the end of the first year is $2.10, the expected price at the end of the second year is $2.205, and so on. The light orange juice project is expected to cannibalize the before-tax profit Citrus Roots earns on its regular orange juice line by $20,000, because the two product lines are somewhat competitive. Further, the company expects cash operating costs to be $1.50 per unit in Year 0 dollars, and the executive committee expects these costs to increase by 2 percent per year. Therefore, total operating cash costs during the first year of operation (Year 1) are expected to be ($1.50)(1.02)(425,000) = $650,250. Citrus Roots tax rate is 40 percent, and its cost of capital is 10 percent. When Aurelia and Sean presented their initial (Case A) analysis to Citrus Roots executive committee, things went well, and they were congratulated on both their analysis and their presentation. However, several questions were raised. In particular, the executive committee wanted to see some type of risk analysis on the projectit appeared to be profitable, but what were the chances that it might nevertheless turn out to be a loser, and how should risk be analyzed and worked into the decision process? As the meeting was winding down, Aurelia and Sean were asked to start with the base case situation they had developed and then to discuss risk analysis, both in general terms and as it should be applied to the light orange juice project. To begin, Aurelia and Sean met with the marketing and production managers to get a feel for the uncertainties involved in the cash flow estimates. After several sessions, they concluded that there was little uncertainty in any of the estimates except for unit sales and salvage value. Cost and sales price estimates were fairly well defined, but unit sales could vary widely. Also, the realized salvage value could be quite different from the $100,000 estimate. (In theory, sales price is also uncertain, but companies typically set sales prices on the basis of competitors prices, so, at least initially, it can be treated as certain.) As estimated by the marketing staff, if product acceptance were normal, then sales quantity during Year 1 would be 425,000 units; if acceptance were poor, then only 200,000 units would be sold (the price would be kept at the forecasted level); and if consumer response were strong, then sales volume for Year 1 would be 650,000 units. In all cases, the price would increase at the inflation rate; hence, Year 1 revenues stated in Year 1 dollars, as they would appear on the income statement, would be $892,500 under the expected conditions, they would be only $420,000 if things went badly, and they would amount to $1,365,000 if things went especially well. Cash costs per unit would remain at $1.50 before adjusting for inflation, so total cash operating costs in Year 1 would be approximately $650,250 under normal conditions,

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$306,000 in the worst-case scenario, and $994,500 in the best-case scenario. These costs would be expected to increase in each successive year at a 2 percent rate. The production manager believes that the equipments Year 4 salvage value could be as low as zero or as high as $150,000, depending on the amount of wear and tear and the demand for such equipment after 4 years. Aurelia and Sean also discussed the scenarios probabilities with the marketing staff. After considerable debate, they finally agreed on a guesstimate of 25 percent probability of poor acceptance, 50 percent probability of average acceptance, and 25 percent probability of excellent acceptance. In addition, Citrus Roots internal auditors require that all sensitivity analysis consider changes in at least the following three variables: sales quantity, salvage value, and the cost of capital. Company policy also mandates that each of the variables be allowed to deviate from its expected value by plus or minus 10 percent, 20 percent, and 30 percent in such an analysis. Aurelia and Sean also discussed with Mark Smith, Citrus Roots director of capital budgeting, both the risk inherent in Citrus Roots average project and how the company typically adjusts for risk. Based on historical data, Citrus Roots average project has a coefficient of variation of NPV in the range of 0.50 to 1.00, and Smith has been adding or subtracting 3 percentage points to the cost of capital to adjust for differential project risk. When Aurelia and Sean asked about the basis for the 3 percentage point adjustment, Smith stated that the adjustment apparently had no basis except the subjective judgment of John Gerber, a former director of capital budgeting who was no longer with the company. Furthermore, Aurelia stated that the cash flows from the light orange juice project will be negatively correlated with sales of its other juice products. Sean disagrees and believes that sales will be highly correlated with the sales of Citrus Roots other products and the S&P 500. The discussion with Smith raised another issue: Should the projects cost of capital be based on its stand-alone risk, on its risk as measured within the context of the firms portfolio of assets (within-firm, or corporate, risk), or in a market risk context? Citrus Roots target capital structure calls for 50 percent debt and 50 percent common equity, and the before-tax marginal cost of debt is currently 10 percent. Aurelia and Sean also determined that the T-bond rate, which they use as the risk-free rate, is 8 percent, and that the market risk premium is 6 percent. Based on data from the Florida Citrus Producers Association, they estimated a beta for the project of 2.0. Since most members of Citrus Roots executive committee are unfamiliar with modern techniques of risk analysis, Aurelia and Sean decided to first discuss the types of risk that are normally considered in capital budgeting and the strengths and weaknesses of risk analysis. However, they contracted laryngitis. Both will attend the meeting, but neither will be able to communicate verbally. Therefore, you must make the presentation and answer any questions. They did provide you with a written memorandum advising you to double check all cash flow computations before beginning the analysis. When Sean gave you the memo he quietly muttered something that you couldnt quite comprehend about being sure to discuss Monte Carlo at the meeting. You informed him that although its regarded as a nice vacation destination, you have never been there, so you will have to research its relevance to risk analysis.

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Answer the following questions. 1. Using Excel, develop the Base Case. Find the NPV of the Base Case. 2. State and explain each of the three types of risk that are normally considered in capital budgeting. 3. In this case, are these three types of risk highly correlated. Explain. 4. Using Excel, develop the NPVs for sensitivity analyses with respect to the cost of capital, quantity of units sold, and salvage value. Assume that this variable can deviate from its base case, by plus or minus 10, 20 and 30 percent. 5. Provide a sensitivity diagram using your data from part 4. 6. What is the most sensitive variable from your sensitivity analysis? Explain what this means for the estimation of this variable. (3 points) 7. Complete scenario analyses (Worse and Best Case Scenarios). 8. Given the following NPVs (and the information provided in the case), calculate the projects differential risk-adjusted NPV, standard deviation and coefficient of variation. 9. Based on the coefficient of variation you computed, if the firms usual range of project coefficient of variations is between 0.15 and 0.50, explain whether or not this project if a low risk project. (4 points) 10. Explain how you would conduct Monte Carlo simulation for this project. (4 points)