Indian River Citrus Company Case Study

Indian River Citrus Company is a leading producer of fresh, frozen, and made-from-concentratecitrus drinks. The firm was founded in 1929 by Matthew Stewart, a navy veteran who settled inMiami after World War I and began selling real estate. Since real estate sales were booming,Stewarts fortunes soared. His investment philosophy, which he proudly displayed behind hisdesk, was Buy land. They arent making any more of it. He practiced what he preached, butinstead of investing in residential property, which he knew was grossly overvalued, he investedmost of his sales commissions in citrus land located in Floridas Indian River County. Originally,Stewart sold his oranges, lemons, and grapefruit to wholesalers for distribution to grocery stores.However, in 1965, when frozen juice sales were causing the industry to boom, he joined withseveral other growers to form Indian River Citrus Company, which processed its own juices.Today, its Indian River Citrus, Florida Sun, and Citrus Gold brands are sold throughout the UnitedStates.Indian Rivers management is currently evaluating a new productlite orange juice. Studiesdone by the firms marketing department indicate that many people who like the taste of orange juice will not drink it because of its high calorie count. The new product would cost more, but itwould offer consumers something that no other competing orange juice product offers35percent less calories. Lili Romero and Brent Gibbs, recent business school graduates who are nowworking at the firm as financial analysts, must analyze this project, along with two other potentialinvestments, and then present their findings to the companys executive committee.Production facilities for the lite orange juice product would be set up in an unused section of Indian Rivers main plant. Although no one has expressed an interest in this portion of the plant,management wants to know how the analysis could incorporate the interest of another citrus inleasing the lite orange juice production site for $25,000 a year. Relatively inexpensive, usedmachinery with an estimated cost of only $500,000 would be purchased, but shipping costs tomove the machinery to Indian Rivers plant would total $20,000, and installation charges wouldadd another $50,000 to the total equipment cost. Further, Indian Rivers inventories (rawmaterials, work-in-process, and finished goods) would have to be increased by $10,000 at the timeof the initial investment. The machinery has a remaining economic life of four years, and thecompany has obtained a special tax ruling that allows it to depreciate the equipment under theMACRS 3-year class. Under current tax law, the depreciation allowances are 0.33, 0.45, 0.15, and0.07 in Years 1 through 4, respectively. The machinery is expected to have a salvage value of $100,000 after four years of use.The section of the main plant where the lite orange juice production would occur has beenunused for several years, and consequently it has suffered some deterioration. Last year, as part of a routine facilities improvement program, Indian River spent $100,000 to rehabilitate that sectionof the plant. Brent believes that this outlay, which has already been paid and expensed for taxpurposes, should be charged to the lite orange juice project. His contention is that if the Case 12 Indian River Citrus Company (A) Capital Budgeting Directed 1994 South-Western, a part of Cengage Learning rehabilitation had not taken place, the firm would have to spend the $100,000 to make the sitesuitable for the orange juice production line.Indian Rivers management expects to sell 425,000 16-ounce cartons of the new orange juiceproduct in each of the next four years, at a price of $2.00 per carton, of which $1.50 per cartonwould be needed to cover fixed and variable cash operating costs. Since most of the costs arevariable, the fixed and variable cost categories have been combined. Also, note that operating costchanges are a function of the number of units sold rather than unit price, so unit price changeshave no effect on operating costs.In examining the sales figures, Lili Romero noted a short memo from Indian Rivers salesmanager which expressed concern that the lite orange juice project would cut into the firms salesof regular orange juicethis type of effect is called cannibalization. Specifically, the salesmanager estimated that regular orange juice sales would fall by 5 percent if lite orange juice wereintroduced. Lili then talked to both the sales and production managers and concluded that the newproject would probably lower the firms regular orange juice sales by $40,000 per year, but, at thesame time, it would also reduce regular orange juice production costs by $20,000 per year, all on apre-tax basis. Thus, the net cannibalization effect would be -$40,000 + $20,000 = -$20,000. IndianRivers federal-plus-state tax rate is 40 percent, and with a 10 percent cost of debt and a 14 percentcost of equity, its overall cost of capital is 10 percent, calculated as follows:WACC = w d k d (1 - T) + w s k s = 0.5(10%)(1-.4) + 0.5(14%)= 10.0%. Case Questions. 1.) Define the term "incremental cash flow" Since the project will be financed in part by debt, should the cash flow statement include interest expenses? Explain 2.) Should the $100,000 that was spent to rehabilitate the plant be included in the analysis? Explain. 3.) Suppose another citrus producer had expressed an interest in leasing the lite orange juice production site for $25,000 a year. If this were true(in fact it was not), how would that information be incorporated into the analysis? 4.) What is Indian River's Year 0 net investment outlay on this project? What is the expected non operating cash flow when the project is terminated at year 4? 5.) Estimate the project's operating cash flows. What are the projects NPV, IRR, modified IRR (MIRR) and payback? Should the project be undertaken?

Cash Flow Statements: Year o Year 1 Year 2 Year 3 Year 4 $ Unit price 3 3 $ Unit sales 425,000 X 425.000 Revenues 1.275.000 X 1.275.000 X 637.500 X X 637.500 Operating costs Depreciation 221,100 X 46.900 20.000 X X Other project effects 20.000 396,400 Before tax income X 570,600 158.560 X X Taxes 228.240 237,840 X X 342.360 Net income 221.100 X 46.200 Plus depreciation 458.940 X X 389.260 Net op cash flow 100,000 Salvage value X SV tax Recovery of NWC Termination CF X X X X X Project NCF 0 BE e here to search OP O Cash Flow Statements: Year o Year 1 Year 2 Year 3 Year 4 $ Unit price 3 3 $ Unit sales 425,000 X 425.000 Revenues 1.275.000 X 1.275.000 X 637.500 X X 637.500 Operating costs Depreciation 221,100 X 46.900 20.000 X X Other project effects 20.000 396,400 Before tax income X 570,600 158.560 X X Taxes 228.240 237,840 X X 342.360 Net income 221.100 X 46.200 Plus depreciation 458.940 X X 389.260 Net op cash flow 100,000 Salvage value X SV tax Recovery of NWC Termination CF X X X X X Project NCF 0 BE e here to search OP O