LILIVU VUIPLIULU, LILL. Adams Wineries is a leading California wine producer. The firm was founded in 1948 by Charles Adams, an army veteran who had spent several years in France both before and after World War II, and who was convinced that California could produce wines that were as good as or better than the best France had to offer. Originally, Adams sold his wine to wholesalers for distribution under their brand names, but in the early 1950s, when wine sales were expanding rapidly, he joined with several other producers to form Adams Wineries, which then began an aggressive promotion campaign. Today, its wines are sold throughout the United States. Adams's management is currently evaluating a potential new product; a light, fruity wine designed to appeal to the younger generation. The new product, California Gold, would be positioned between the various wine coolers and the traditional wines. The new product would cost more than wine coolers, but less than premium table wine, and in market research samplings at the company's Napa headquarters, it was judged superior to various competing products. Jeanie Resce, the financial vice president, must analyze this project, along with other potential investments, and then present her findings to the company's executive committee. Production facilities for the new wine product would be set up in an unused section of Adams's main plant. Relatively inexpensive, used machinery with an estimated cost of only $500,000 would be purchased, but shipping costs to move the machinery to Adams's plant would total $40,000, and installation charges would add another $60,000 to the total equipment cost. Further, Adams's inventories (the new product requires some aging at the winery) would have to be increased by $20,000, and this cash flow is assumed to occur at the time of the initial investment. The machinery has a remaining useful life of 4 years, and the company has obtained a special tax ruling that allows it to depreciate the equipment under the MACRS 3-year class life. Under current tax law, the depreciation allowances are 0.33,0.45,0.15, and 0.07 in Years I through 4, respectively. The machinery is expected to have an after-tax salvage value of $50,000 after 4 years of use. The section of the plant in which production would occur has not been used for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, Adams spent $200,000 to rehabilitate that section of the main plant. Dan Smith, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the wine project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $200,000 to make the site suitable for the wine project. Adams's management expects to sell 200,000 bottles of the new wine product in the first year, with unit sales growing by 6% per year for the following 3 years (After the 4th year, the project will be terminated). The product is expected to sell at a wholesale price of $4.50 per bottle, but $3.35 per bottle would be needed to cover cash operating costs. In examining the sales figures, Resce noted a short memo from Adams's sales manager which expressed concern that the wine project would cut into the firm's sales of wine coolersthis type of effect is called erosion. Specifically, the sales manager estimated that wine cooler sales would fall by 5 percent if the new wine were introduced. Resce then talked to both the sales and production managers, and she concluded that the new project would probably lower the firm's wine cooler sales by $40,000 per year, but, at the same time, it would also reduce production costs for this product by $20,000 per year, all on a pre-tax basis. Thus, the net erosion effect would be -$40,000+ $20,000 = $20,000. Adams's federal-plus-state tax rate is 40 percent. Management believes the California Gold project carries a level of risk similar to that of Adams' existing lines of business, and therefore intends to evaluate the project against the firm's weighted average cost of capital, which is currently estimated to be approximately 11.5%. A 1 2 3 5 Assumptions Year 1 Unit Sales Annual growth rate in unit sales Selling Price Variable Cost per unit Annual erosion cost Capital Expenditure Investment in Net Working Capital Tax Rate After-tax Salvage Value Cost of Capital 8 9 10 11 13 MACRS Depreciation % 33.00% 45.00% 15.00% 7.00% 17 Project Income Statement Year 19 20 21 22 23 24 25 26 Unit Sales Revenue Variable Costs Cost of Erosion Depreciation EBIT Taxes Net Income LILIVU VUIPLIULU, LILL. Adams Wineries is a leading California wine producer. The firm was founded in 1948 by Charles Adams, an army veteran who had spent several years in France both before and after World War II, and who was convinced that California could produce wines that were as good as or better than the best France had to offer. Originally, Adams sold his wine to wholesalers for distribution under their brand names, but in the early 1950s, when wine sales were expanding rapidly, he joined with several other producers to form Adams Wineries, which then began an aggressive promotion campaign. Today, its wines are sold throughout the United States. Adams's management is currently evaluating a potential new product; a light, fruity wine designed to appeal to the younger generation. The new product, California Gold, would be positioned between the various wine coolers and the traditional wines. The new product would cost more than wine coolers, but less than premium table wine, and in market research samplings at the company's Napa headquarters, it was judged superior to various competing products. Jeanie Resce, the financial vice president, must analyze this project, along with other potential investments, and then present her findings to the company's executive committee. Production facilities for the new wine product would be set up in an unused section of Adams's main plant. Relatively inexpensive, used machinery with an estimated cost of only $500,000 would be purchased, but shipping costs to move the machinery to Adams's plant would total $40,000, and installation charges would add another $60,000 to the total equipment cost. Further, Adams's inventories (the new product requires some aging at the winery) would have to be increased by $20,000, and this cash flow is assumed to occur at the time of the initial investment. The machinery has a remaining useful life of 4 years, and the company has obtained a special tax ruling that allows it to depreciate the equipment under the MACRS 3-year class life. Under current tax law, the depreciation allowances are 0.33,0.45,0.15, and 0.07 in Years I through 4, respectively. The machinery is expected to have an after-tax salvage value of $50,000 after 4 years of use. The section of the plant in which production would occur has not been used for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, Adams spent $200,000 to rehabilitate that section of the main plant. Dan Smith, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the wine project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $200,000 to make the site suitable for the wine project. Adams's management expects to sell 200,000 bottles of the new wine product in the first year, with unit sales growing by 6% per year for the following 3 years (After the 4th year, the project will be terminated). The product is expected to sell at a wholesale price of $4.50 per bottle, but $3.35 per bottle would be needed to cover cash operating costs. In examining the sales figures, Resce noted a short memo from Adams's sales manager which expressed concern that the wine project would cut into the firm's sales of wine coolersthis type of effect is called erosion. Specifically, the sales manager estimated that wine cooler sales would fall by 5 percent if the new wine were introduced. Resce then talked to both the sales and production managers, and she concluded that the new project would probably lower the firm's wine cooler sales by $40,000 per year, but, at the same time, it would also reduce production costs for this product by $20,000 per year, all on a pre-tax basis. Thus, the net erosion effect would be -$40,000+ $20,000 = $20,000. Adams's federal-plus-state tax rate is 40 percent. Management believes the California Gold project carries a level of risk similar to that of Adams' existing lines of business, and therefore intends to evaluate the project against the firm's weighted average cost of capital, which is currently estimated to be approximately 11.5%. A 1 2 3 5 Assumptions Year 1 Unit Sales Annual growth rate in unit sales Selling Price Variable Cost per unit Annual erosion cost Capital Expenditure Investment in Net Working Capital Tax Rate After-tax Salvage Value Cost of Capital 8 9 10 11 13 MACRS Depreciation % 33.00% 45.00% 15.00% 7.00% 17 Project Income Statement Year 19 20 21 22 23 24 25 26 Unit Sales Revenue Variable Costs Cost of Erosion Depreciation EBIT Taxes Net Income