Question
It is January 1st, 2018. You are a senior analyst at America Coffee House Inc. (ACH), one of the leading coffee chains and wholesaler of
It is January 1st, 2018. You are a senior analyst at America Coffee House Inc. (ACH), one of the leading coffee chains and wholesaler of coffee/bakery products in North America. The CEO of America Coffee House, Susan Matthews, has reached out to you to draft a report to evaluate two investment proposals, building on your analysis from Assignment 1.
Purpose
For this case approach, you will demonstrate your ability to develop costing methods and a set of forecasts of future cash flows for two proposed investment projects. You will also be required to identify the cost of financing through the issuance of bonds.
Bond yield to utilize: is 7.17% (aka required rate of return)
- Prepare a summary narrative (i.e., a detailed description) of each proposal with detailed elements on the initial investment, as well as the costs/revenues over the life of each of the projects. Identify which revenues and costs are relevant to your analysis, and which costs are irrelevant. Identify the time horizon for each investment.
- Calculate the after-tax cash flows during the life of each of the projects. Be sure to identify the total costs of ownership and deduct those costs from the benefits to arrive at the net cash inflow per year.
- Utilizing the after-tax cash flows from part 4, evaluate each investment proposal utilizing the following criteria (unless directed otherwise):
- Payback;
- Discounted payback;
- NPV;
- IRR; and
- Profitability index.
- Clearly indicate whether any of the above criteria support each of the project proposals, and what the company should ultimately decide to do.
Investment Proposals
Susan Matthews, CEO of ACH, wants you to evaluate two investment proposals that the company is considering:
- The purchase of a coffee roaster plant in Puerto Rico; and
- The re-development of coffee shops to accommodate the selling of frozen yogurt.
Ms. Matthews reminds you that only relevant costs and revenues should be considered. "Relevant costs have to be occurring in the future," explained Ms. Matthews, "and have to differ from the status quo. For example, if we choose to buy the roaster plant, it is only theincremental revenue and costsrelated to the purchase that should be considered. We also need to take into account the opportunity costs associated with the alternatives. For example, for the coffee shop development, we need to factor in the lost sales, due to yogurt sales cannibalizing some of our coffee sales."
More details on each investment proposal are included below. Ms. Matthews wants you to recommend if ACH should invest in one, both, or none of the investment proposals.
Required Return
Ms. Matthews wants you to use the weighted average bond yield for your required return. The total market value of debt that ACH is expected to have going into this investment is $120M, which includes the impact of the $40M to be paid off this year that has not been included in the financial statements. The current outstanding debt has an interest rate of 8%, but ACH is refinancing $50M of the debt at a lower interest rate of 6%. All of the $120M in debt is in the form of bonds. Ignore income tax effects when calculating the required return (i.e., do not take the after-tax cost of debt). Use current interest rates as a proxy for bond yield.
Investment in Roasted Coffee Plant
Ms. Matthews is considering purchasing a coffee plant in Puerto Rico, where labour is cheap, and there are proximal coffee farms to help lower transportation costs.
The acquisition price of the plant is $6M, which includes roasting equipment that originally cost $14M when it was purchased eight years ago. Some of the equipment is on its last legs, so an additional $2M of equipment has to be purchased. The roaster plant currently has $2M of available tax shield left, excluding any tax shield related to the equipment to be purchased.
The direct materials and direct labour used to manufacture these products are 8% and 7% of sales, respectively. The actual roasting processing costs are approximately 17% of sales. These costs, as a percentage of sales, are expected to remain consistent over the time horizon. The plant also requires two managers with fixed salaries of $50,000 each per year. Insurance for the plant and equipment is $40,000 per year. Otherincrementalmanufacturing overhead costs (property taxes, maintenance, security, etc.), excluding depreciation, are estimated to be $75,000 annually. Wages are expected to increase with inflation (estimated to be 2%) over the time period, while other fixed costs are expected to remain steady.
Variable transportation costs (gas, truck driver salaries, etc.) are estimated to be 12% of incremental revenue and include transportation of raw materials to the roaster and finished products to the port for delivery to ACH coffeehouses.
The roasted coffee plant is expected to produce 1.1M pounds of coffee for the first two years, with production dipping by 100,000 pounds per year after this, due to lower productivity from the deteriorating equipment. Each pound of roasted coffee can be sold at $3.25 per pound (either to ACH retail cafes, franchise cafes, or to wholesale partners), with the price expected to rise with inflation over time. Each pound of coffee can make 30 cups of coffee that can sell at an average retail price of $4.00 per cup. Ms. Matthews has stressed that the profitability of the plant base has to be looked at on a stand-alone basis (i.e., from the sales from the plant to buyers), not from retail cafs to customers.
Ms. Matthews wants to see if the project will reach profitability after 5 years, as significant reinvestment will be needed after five years to keep the plant operational. She wants you to evaluate the return on investment in that period using the investment criteria of payback period, discounted payback period, NPV, IRR, and profitability index. The following table will help in the calculations of the tax shield for the new equipment:
Class | CCA Rate | Description |
---|---|---|
43 | 30% | Machine and equipment to manufacture and process goods for sale |
Tax Shield Formula
Assume no salvage value when calculating the tax shield, and that the half-year rule applies for each class. The tax rate Ms. Matthews wants you to utilize is 25%. When calculating the tax shield, the present value should be in the same period as the initial investment (Year 0), which also means that deprecation (i.e., CCA) should not be taken from the cash flows in subsequent years, since their tax shelter effects are already accounted for in the tax shield.
Redevelopment of Coffee Shops
Ms. Matthews also wants you to evaluate the potential of developing several hundred stores into new store models with frozen yogurt services. Five hundred stores have been selected as candidates for development. It will cost $80,000 to convert each store, including modifications to refrigeration equipment, with these costs being capitalized with a 6% applicable CCA rate. The average modified coffee shop is expected to generate an additional $30,000 in after-tax cash flow every year. However, ACH is also estimated to lose about $15,000 in annual after-tax cash flow from these cafs, due to yogurt sales cannibalizing existing coffee shops. In other words, some customers who normally would have purchased coffee would instead purchase yogurt.
The five hundred stores have average annual rent of $36,000 each. Ms. Matthews wants you to evaluate the profitability of this investment after a seven year period, using the investment criteria of NPV and profitability index.
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