PALO ALTO MICRO-BREWING CO.1 It is November 2020. Kasim Nasser, an entrepreneur in the Silicon Valley, has just founded Palo Alto Micro-Brewing Co. (PAMBCo), a very fancy high-quality micro-brewery in the Bay Area, California. He is the sole owner and CEO of the company. PAMBCo is considering acquiring at the end of 2020 a $4 million Brauhaus 1000A, a large microbrewery system. This investment has an economic life of eight years. In the U.S., it falls into the 7-year property class for depreciation purposes under the modified accelerated cost recovery system (MACRS). As a result, the schedule permits depreciation of 14.29% in the first year, 24.49% in the second year, 17.49% in the third year, 12.49% in the fourth year, 8.93% in the fifth year, 8.92% in the sixth year, 8.93% in the seventh year, and 4.46% in the eighth year. PAMBCo plans to keep the new microbrewery system for five years, until the end of 2025. At this point, Kasim believes he will be able to sell the system to another beer enthusiast for $1 million. He plans to close down shop in 2026. A pre-market estimate shows that in 2021, PAMBCo will be able to sell 400,000 bottles of beer at a price of $5/bottle. In 2021-2026, the demand for the companys product is expected to increase by 50,000 bottles annually. The cost of production is expected to remain constant at $1/bottle. All sales are attributable to PAMBCos new microbrewery system. PAMBCos combined marketing and overhead cost in 2020 is expected to be $200,000. In 2021- 2025, this cost is expected to be $375,000. In 2026, there will be no marketing and overhead cost. PAMBCos product will not go on sale until 2021, but in 2020 the plan is to produce 100,000 bottles prior to the initial 2021 launch. In 2021-2025, the plan is to keep end-of-year inventories equal to 25% of the next years anticipated demand. In 2026, the plan is to simply sell the remaining inventory, thus only satisfying 25% of the annual demand. To value investment in Brauhaus 1000A, Kasim must make several assumptions. First, he assumes that all numbers are year-end figures. Second, he assumes that 2020 payments are made at year- end (and to make discounting easier he values the project on December 31, 2020). Third, even though the equipment is put into use in 2020 to produce the initial inventory, Kasim assumes that first depreciation expense is only taken in 2021. This is because there is too little of 2020 left to risk conflict with the U.S. Internal Revenue Service. Fourth, he assumes that the project will entail no accounts receivable and accounts payable. Finally, he assumes that PAMBCo can use the tax carry This mini-case is written by Professor Alexander S. Gorbenko for use in classroom discussion. Published 15 November 2022 forward provision in the U.S. tax code to decrease its tax in 2021, offsetting the firms loss in 2020. As an aside, there is no tax carry back allowed in the U.S. since 2018. PAMBCos additional base-case assumptions: the corporate tax rate is 21%; the risk-free rate is 2%; companies with risk similar to PAMBCo have a 12% required return. Questions: a. What are PAMBCos annual free-cash flows in years 2020-2026? b. What is the NPV of PAMBCos investment in Brauhaus 1000A? c. What is the payback period and IRR of the investment? If PAMBCos patience level is 4 years, does the payback rule coincide with the NPV rule? Does the IRR rule coincide with the NPV rule? d. Kasims friend and former MBA classmate believes that PAMBCo can afford an annual price increase of $0.5/bottle while keeping its initial demand of 400,000 bottles unchanged in 2020-2026. Should Kasim listen to his friend? Explain intuitively why or why not. e. You are hired by PAMBCo as an independent financial adviser. You decide to dig deeper into the price-demand link. You study comparable micro-breweries and realize that an annual $0.1/bottle price increase corresponds to a 10,000 bottle drop in annual demand growth. As an example, no price increase results in the annual demand increase of 50,000 bottles, as per Kasims initial analysis. As another example, an annual $0.5/bottle price increase results in an unchanged annual demand, confirming Kasims friends belief. What annual price increase delivers the highest NPV? What is the largest price increase that leaves the project barely financially viable?