Needed help with question number 11.

11. Refer back to the original lite orange juice project. In this and the remaining questions, if you are using the spreadsheet model, quantify your answer. Otherwise, just discuss the impact of the changes.

a. What would happen to the projects profitability if inflation were neutral, that is, if both

sales price and cash operating costs increase by the 5 percent annual inflation rate?

b. Now suppose that Indian River is unable to pass along its inflationary input cost increases

to its customers. For example, assume that cash operating costs increase by the 5 percent

annual inflation rate, but that the sales price can be increased at only a 2 percent annual

rate. What is the projects profitability under these conditions?

rehabilitation had not taken place, the firm would have to spend the $100,000 to make the site suitable for the orange juice production line. Indian River's management expects to sell 425,000 16-ounce cartons of the new orange juice product in each of the next four years, at a price of $2.00 per carton, of which $1.50 per carton would be needed to cover 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 changes are a function of the number of units sold rather than unit price, so unit price changes have no effect on operating costs. In examining the sales figures, Lili Romero noted a short memo from Indian River's sales manager which expressed concem that the lite orange juice project would cut into the firm's sales of regular orange juice this type of effect is called cannibalization. Specifically, the sales manager estimated that regular orange juice sales would fall by 5 percent if lite orange juice were introduced. Lili then talked to both the sales and production managers and concluded that the new project would probably lower the firm's regular orange juice sales by $40,000 per year, but, at the same time, it would also reduce regular orange juice production costs by $20,000 per year, all on a pre-tax basis. Thus, the net cannibalization effect would be -S40,000+ $20,000 = -$20,000. Indian River's federal-plus-state tax rate is 40 percent, and with a 10 percent cost of debt and a 14 percent cost of equity, its overall cost of capital is 10 percent, calculated as follows: WACC = wkI-T) + wk = 0.5(10%X1-4) +0.5(14%) = 10,0% Lili and Brent were asked to analyze this project, along with two other projects discussed below, and then to present their findings in a "tutorial" manner to Indian River's executive committee. They were also asked to extend their original presentation to explain how inflation of percent per year over the next four years would impact the analysis and how the analysis would change if the decision had been to replace an existing machine rather than to expand an existing facility. The second capital budgeting decision which Lili and Brent were asked to analyze involves choosing between two mutually exclusive projects, S and L, whose cash flows are set forth below: Year Expected Net Cash Flow Project S Project L ($100,000) ($100,000) 60,000 33,500 60,000 33.500 33,500 33.500 Both of these projects are in Indian River's main line of business and have average risk, hence cach is assigned the 10 percent corporate cost of capital. The investment, which is chosen, is expected to be repeated indefinitely into the future. Lili and Brent are concemed about inflationary pressures. Therefore they believe it would be useful to also assume that the cost to replicate Project S in two years is estimated to be $105.000 and similar investment cost increases would occur for both projects in Year 4 and beyond. The third project to be considered involves a fleet of delivery trucks with an engineering life of three years (that is, each truck will be totally wom out after three years). However, if the trucks were taken out of service, or "abandoned." prior to the end of three years, they would have positive salvage values. Here are the estimated net cash flows for each truck: Initial Investment and Operating Cash Flow End-of-Year Net Abandonment Cash Flow $40.000 24.800 16,000 ($40,000) 16.800 16.000 14.000 Given the relevant cost of capital is again 10 percent. Lili and Brent have been asked to analyze the NPV over the trucks full 3 years of operation as well as carlier abandonment. The financial vice president, Lili and Brent's supervisor, wants them to educate some of the other executives, especially the marketing and sales managers, in the theory of capital budgeting so that these executives will have a better understanding of capital budgeting decisions. Therefore, Lili and Brent have decided to ask and then answer a series of questions as set forth below. 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 Onet investment outlay on this project? What is the expected nonoperating cash flow when the project is terminated at Year 47 (Hint: Use Table lasa guide.) 5. Estimate the project's operating cash flows. (Hint: Again use Table 1 as a guide.) What are the project's NPV, IRR, modified IRR (MIRR), and payback? Should the project be undertaken? [Remember: The MIRR is found in three steps: (1) compound all cash inflows forward to the terminal year at the cost of capital, (2) sum the compounded cash inflows to obtain the terminal value of the inflows, and (3) find the discount rate which forces the present value of the terminal value to equal the present value of the net investment outlays. This discount rate is defined as the MIRR.) 6. Now suppose the project had involved replacement rather than expansion of existing facilities. Describe briefly how the analysis would have to be changed to deal with a replacement project. 7. Assume that inflation is expected to average 5 percent per year over the next four years. a. Does it appear that the project's cash flow estimates are real or nominal? That is, are the cash flows stated in constant (current year) dollars, or has inflation been built into the cash flow estimates? (Hint: Nominal cash flows include the effects of inflation, but real cash flows do not.) b. Is the 10 percent cost of capital a nominal or a real rate? c. Is the current NPV biased, and, if so, in what direction? 8. Now assume that the sales price will increase by the 5 percent inflation rate beginning after Year 0. However, assume that cash operating costs will increase by only 2 percent annually from the initial cost estimate, because over half of the costs are fixed by long-term contracts. For simplicity, assume that no other cash flows (net externality costs, salvage value, or net working capital) are affected by inflation. What are the project's NPV, IRR, MIRR, and payback now that inflation has been taken into account? (Hint: The Year 1 cash flows, as well as succeeding cash flows, must be adjusted for inflation because the original estimates are in Year O dollars.) 9. The second capital budgeting decision which Lili and Brent were asked to analyze involves choosing between two mutually exclusive projects, S and L. whose cash flows are set forth as follows: Expected Net Cash Flow Year Projects Project L ($100.000) ($100,000) 60,000 33.500 60,000 33,500 33,500 33,500 Both of these projects are in Indian River's main line of business, orange juice, and the investment, which is chosen, is expected to be repeated indefinitely into the future. Also, each project is of average risk, hence each is assigned the 10 percent corporate cost of capital a. What is each project's single-cycle NPV? Now apply the replacement chain approach and then repeat the analysis using the equivalent annual annuity approach. Which project should be chosen, Sor L? Why? b. Now assume that the cost to replicate Project S in two years is estimated to be $105,000 because of inflationary pressures. Similar investment cost increases will occur for both projects in Year 4 and beyond. How would this affect the analysis? Which project should be chosen under this assumption? 10. The third project to be considered involves a fleet of delivery trucks with an engineering life of three years that is, each truck will be totally worn out after three years). However, if the trucks were taken out of service, or "abandoned," prior to the end of three years, they would have positive salvage values. Here are the estimated net cash flows for each truck: Initial Investment and Operating Cash Flow Year End-of-Year Net Abandonment Cash Flow $40.000 24.800 16,000 (540.000) 16,800 16,000 14.000 The relevant cost of capital is again 10 percent. a. What would the NPV be if the trucks were operated for the full three years? b. What if they were abandoned at the end of Year 2? What if they were abandoned at the end of Year 12 c. What is the economic life of the truck project? 11. Refer back to the original lite orange juice project. In this and the remaining questions, if you are using the spreadsheet model, quantify your answer. Otherwise, just discuss the impact of the changes. a. What would happen to the project's profitability if inflation were neutral, that is, if both sales price and cash operating costs increase by the 5 percent annual inflation rate? b. Now suppose that Indian River is unable to pass along its inflationary input cost increases to its customers. For example, assume that cash operating costs increase by the 5 percent rehabilitation had not taken place, the firm would have to spend the $100,000 to make the site suitable for the orange juice production line. Indian River's management expects to sell 425,000 16-ounce cartons of the new orange juice product in each of the next four years, at a price of $2.00 per carton, of which $1.50 per carton would be needed to cover 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 changes are a function of the number of units sold rather than unit price, so unit price changes have no effect on operating costs. In examining the sales figures, Lili Romero noted a short memo from Indian River's sales manager which expressed concem that the lite orange juice project would cut into the firm's sales of regular orange juice this type of effect is called cannibalization. Specifically, the sales manager estimated that regular orange juice sales would fall by 5 percent if lite orange juice were introduced. Lili then talked to both the sales and production managers and concluded that the new project would probably lower the firm's regular orange juice sales by $40,000 per year, but, at the same time, it would also reduce regular orange juice production costs by $20,000 per year, all on a pre-tax basis. Thus, the net cannibalization effect would be -S40,000+ $20,000 = -$20,000. Indian River's federal-plus-state tax rate is 40 percent, and with a 10 percent cost of debt and a 14 percent cost of equity, its overall cost of capital is 10 percent, calculated as follows: WACC = wkI-T) + wk = 0.5(10%X1-4) +0.5(14%) = 10,0% Lili and Brent were asked to analyze this project, along with two other projects discussed below, and then to present their findings in a "tutorial" manner to Indian River's executive committee. They were also asked to extend their original presentation to explain how inflation of percent per year over the next four years would impact the analysis and how the analysis would change if the decision had been to replace an existing machine rather than to expand an existing facility. The second capital budgeting decision which Lili and Brent were asked to analyze involves choosing between two mutually exclusive projects, S and L, whose cash flows are set forth below: Year Expected Net Cash Flow Project S Project L ($100,000) ($100,000) 60,000 33,500 60,000 33.500 33,500 33.500 Both of these projects are in Indian River's main line of business and have average risk, hence cach is assigned the 10 percent corporate cost of capital. The investment, which is chosen, is expected to be repeated indefinitely into the future. Lili and Brent are concemed about inflationary pressures. Therefore they believe it would be useful to also assume that the cost to replicate Project S in two years is estimated to be $105.000 and similar investment cost increases would occur for both projects in Year 4 and beyond. The third project to be considered involves a fleet of delivery trucks with an engineering life of three years (that is, each truck will be totally wom out after three years). However, if the trucks were taken out of service, or "abandoned." prior to the end of three years, they would have positive salvage values. Here are the estimated net cash flows for each truck: Initial Investment and Operating Cash Flow End-of-Year Net Abandonment Cash Flow $40.000 24.800 16,000 ($40,000) 16.800 16.000 14.000 Given the relevant cost of capital is again 10 percent. Lili and Brent have been asked to analyze the NPV over the trucks full 3 years of operation as well as carlier abandonment. The financial vice president, Lili and Brent's supervisor, wants them to educate some of the other executives, especially the marketing and sales managers, in the theory of capital budgeting so that these executives will have a better understanding of capital budgeting decisions. Therefore, Lili and Brent have decided to ask and then answer a series of questions as set forth below. 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 Onet investment outlay on this project? What is the expected nonoperating cash flow when the project is terminated at Year 47 (Hint: Use Table lasa guide.) 5. Estimate the project's operating cash flows. (Hint: Again use Table 1 as a guide.) What are the project's NPV, IRR, modified IRR (MIRR), and payback? Should the project be undertaken? [Remember: The MIRR is found in three steps: (1) compound all cash inflows forward to the terminal year at the cost of capital, (2) sum the compounded cash inflows to obtain the terminal value of the inflows, and (3) find the discount rate which forces the present value of the terminal value to equal the present value of the net investment outlays. This discount rate is defined as the MIRR.) 6. Now suppose the project had involved replacement rather than expansion of existing facilities. Describe briefly how the analysis would have to be changed to deal with a replacement project. 7. Assume that inflation is expected to average 5 percent per year over the next four years. a. Does it appear that the project's cash flow estimates are real or nominal? That is, are the cash flows stated in constant (current year) dollars, or has inflation been built into the cash flow estimates? (Hint: Nominal cash flows include the effects of inflation, but real cash flows do not.) b. Is the 10 percent cost of capital a nominal or a real rate? c. Is the current NPV biased, and, if so, in what direction? 8. Now assume that the sales price will increase by the 5 percent inflation rate beginning after Year 0. However, assume that cash operating costs will increase by only 2 percent annually from the initial cost estimate, because over half of the costs are fixed by long-term contracts. For simplicity, assume that no other cash flows (net externality costs, salvage value, or net working capital) are affected by inflation. What are the project's NPV, IRR, MIRR, and payback now that inflation has been taken into account? (Hint: The Year 1 cash flows, as well as succeeding cash flows, must be adjusted for inflation because the original estimates are in Year O dollars.) 9. The second capital budgeting decision which Lili and Brent were asked to analyze involves choosing between two mutually exclusive projects, S and L. whose cash flows are set forth as follows: Expected Net Cash Flow Year Projects Project L ($100.000) ($100,000) 60,000 33.500 60,000 33,500 33,500 33,500 Both of these projects are in Indian River's main line of business, orange juice, and the investment, which is chosen, is expected to be repeated indefinitely into the future. Also, each project is of average risk, hence each is assigned the 10 percent corporate cost of capital a. What is each project's single-cycle NPV? Now apply the replacement chain approach and then repeat the analysis using the equivalent annual annuity approach. Which project should be chosen, Sor L? Why? b. Now assume that the cost to replicate Project S in two years is estimated to be $105,000 because of inflationary pressures. Similar investment cost increases will occur for both projects in Year 4 and beyond. How would this affect the analysis? Which project should be chosen under this assumption? 10. The third project to be considered involves a fleet of delivery trucks with an engineering life of three years that is, each truck will be totally worn out after three years). However, if the trucks were taken out of service, or "abandoned," prior to the end of three years, they would have positive salvage values. Here are the estimated net cash flows for each truck: Initial Investment and Operating Cash Flow Year End-of-Year Net Abandonment Cash Flow $40.000 24.800 16,000 (540.000) 16,800 16,000 14.000 The relevant cost of capital is again 10 percent. a. What would the NPV be if the trucks were operated for the full three years? b. What if they were abandoned at the end of Year 2? What if they were abandoned at the end of Year 12 c. What is the economic life of the truck project? 11. Refer back to the original lite orange juice project. In this and the remaining questions, if you are using the spreadsheet model, quantify your answer. Otherwise, just discuss the impact of the changes. a. What would happen to the project's profitability if inflation were neutral, that is, if both sales price and cash operating costs increase by the 5 percent annual inflation rate? b. Now suppose that Indian River is unable to pass along its inflationary input cost increases to its customers. For example, assume that cash operating costs increase by the 5 percent