QUESTIONS 1. Defne the term "incremental cash fow." Since the project will be fnanced in part by debt, should the cash fow statement include interest expenses? Explain. Yes. az the interest egove wil affect the anschthon 2. Should the $100,000 that was spent to rehabilitate the plant be included in the analysis? Explain. 3. (a) 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? 3. (b) The new project will lower sales of existing regular orange juice by $40,000 p.a., but reduces its production costs by $20,000 p.a. Should the net cannibalization effect of $20,000 p.a. be included in the analysis? 4. What is Indian River's Year 0 net investment outlay on this project? What is the expected nonoperating cash fow when the project is terminated at Year 4? (Hint: Use Table 1 as a guide.) 5. Estimate the project's operating cash fows. (Hint: Again use Table 1 as a guide.) What are the project's NPV, IRR, modif ed IRR (MIRR), and payback? Should the project be under- taken? [Remember: The MIRR is found in three steps: (1) compound all Cash Flow Estimation 12 INDIAN RIVER CITRUS COMPANY (A) Indian River Citrus Company is a leading producer of fresh, frozen, and made-from-concentrate citrus drinks. The firm was founded in 1929 by Matthew Stewart, a navy veteran who settled in Miami her World War I and began selling real estate. Since real estate sales were booming. Stew art's fortunes soured. His investment philosophy, which he proudly displayed behind his desk, was "Buy land. They aren't making any more of it." He practiced what he preached, but instead of invest ing in residential property, which he knew was grossly overvalued, he invested most of his sales commissions in citrus land located in Florida's 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 with several 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 United States. Indian River's management is currently evaluating a new product lite orange juice. Studies done by the firm's marketing department indicate that many people who like the taste of orange juic will not drink it because of its high caloric count. The new product would cost more, but it would offer consumers something that no other competing orange juice product offers 35 percent less Calories. Lili Romero and Brent Gibbs, recent business school graduates who are now working at the firm as financial analysts, must analyze this project, along with two other potential investments, and then present their findings to the company's executive committee Production facilities for the lite orange juice product would be set up in an unused section of Indian River's main plant. Relatively inexpensive, used irachinery with an estimated cost of only $500.000 would be purchased, but shipping costs to move the machinery to Indian River's plant would total $20,000, and installation charges would add another $50,000 to the total equipment cost. Further, Indian River's inventories fraw materials, work-in-process, and finished goods) would have to be icreased by $10.000 at the time of the initial investment. The machinery has a remaining Medways econic life of 4 years, and the company has obtained a special tax ruling that allows it to depre- ciate the equipment under the MACRS 3-year class. Under current tax law, the depreciation allowances are 0.33.0.45.0.15 and 0.07.in Years 1 through 4, respectively. The machinery is expected to have a salvage value of $100,000 after 4 years of use. The section of the main plant where the lite orange juice production would occur has been unused for several years, and consequently it has suffered some deterioration. Last year, as part of a routin-cilities improvement program, Indian River spent $100,000 to rehabilitate that section of the plant. Brent believes that this outlay, which has already been paid and expensed for tax pur. poses, should be charged to the lite orange juice project. His contention is that if the rehabilitation forlify Copyright 1994. The Dryden Press. All rights reserved Case: 12 Cash Flow Estimation had not taken place, the firm yould have to spend the $100,000 to make the site suitable for the range juice, production Indian River's management expects to sell 425,000 16-ounce care of the new orange juice product in each of the next 4 years at a price of $2.00 por caden, of which 51.50 per non would be needed to cover fredavanable cash operating costs. Since most of the cast are variable, the fxed 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 concern that the lite orange juice project would cut into the fm's sales of regular orange juice this type of effect is called cannibalization. Specifically, the sales man- ager estimated that regular orange juice sales would fall by 5 percent if lite orange juice were intro duced. 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 S40,000 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 $10,000+ $20,000 -$20,000. Indian River's federal-plus-state tax rate is 40 percent, and its overall cost of capital is 10 percent, calcu lated as follows: WACC - wkd(1-T) + wsks -0.5(10%X0.6) +0.5(14%) - 10.0% Lili and Brent were asked to analyze this project, along with two other projects, and then to present their findings in a "tutorial manner to Indian River's executive committee. The financial vice president, Lil and Brent's supervisor, wants them to educate some of the other executives, espe cially 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. Specifes on the other two projects that must be analyzed are provided in Questions 9 and 10. QUESTIONS I Defne the term incremental cash fow." Since the project will be fnanced in part by debt, should the cash fow statement include interest expenses? Explain. Y 02 e fect 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? 3. (b) The new project will lower sales of existing regular orange juice by S40,000 p.a., but reduces its production costs by 320,000 p.a. Should the nel Cannibalization effect of $20,000 p.a. be included in the analysis? 4. What is Indian River's Year Onet investment outlay on this project? What is the expected nonoperating cash row when the project is terminated a Year 47 (Hint: Use Table as a guide.) 5. Estimate the project's operating cash fows. (Hint: Again use Table I as a guide.) What are the project's NPV, IRR, modif ed IRR (MIRR), and payback? Should the project be under taken? [Remember: The MIRR is found in three steps: (1) compound all Case: 12 Cash Flow Estimation cash infows forward to the terminal year at the cost of capital. (2) sumn the compounded cash infows to obtain the terminal value of the infows, and (3) fnd 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 defned as the MIRR.] 6. Now suppose the project had involved replacement rather than expansion of existing facilities. Describe bricfy how the analysis would have to be changed to deal with a replacement project. 7. Assume that infation is expected to average 5 percent per year over the next 4 years. a. Does it appear that the project's cash fow estimates are real or nominal? That is, are the cash fows stated in constant (current year) dollars, or has infation been built into the cash fow estimates? (Hint: Nominal cash fows include the effects of infation, but real cash fows 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 infation 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 fxed by long-term contracts. For simplicity, assume that no other cash fows (net externality costs, salvage value, or net working capital) are affected by infation. What are the project's NPV, IRR, MIRR, and pay- back now that infation has been taken into account? (Hint: The Year I cash fows, as well as succeeding cash fows, must be adjusted for infation because the original estimates are in Year 0 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 rows are set forth as follows: Year Expected Net Cash Flow Projects ($100,000) 60,000 60,000 Project L ($100,000) 33,500 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 indefnitely into the future. Also, cach 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 Sin 2 years is estimated to be $105,000 because of infationary 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? C 12 Cash Flow Bima 10. The third project to be considered involves afect of delivery trucks with an engineering life of 3 years that is cach truck will be totally worn after years. However, if the trucks were taken out of service, or "abandoned prior to the end of years, they would have post tive salvage values. Here are the estimated net cash fows for each track End-of-Year Net Abandonment Cash Flow Year Initial Investment and Operating Cash Flow (S40,000) 16.800 16.000 14.000 24 DO 16.000 The relevant cost of capital is again 10 percent. 2. What would the NPV be if the trucks were operated for the full 3 years? b. What if they were abandoned at the end of Year 2? What if they were abandoned at the end of Year 1% c. What is the economic life of the track project! 11. Refar back to the orig i ne enange juice project. In this sad the remaining question quality your answering the Excel spreadsheet model 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 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 project's profitability under these conditions? 12. Return to the initial inflation assumptions (5 percent on price and 2 percent on cash operate ing costs 2. Assume that the sales quantity estimate remains at 425,000 units per year. What Year unit price would the company have to set to cause the project to just break even, that is, to force NPV-50? b. Now assume that the sales price remains at $2. What annual unit sales volume would be needed for the project to break even? Cases 12 Cash Flow Botimation TABLE 1 Project Cash Flow Estimates Depreciation Schedule: Basis Net Investment Outlay Price Freight Installation Change in NWC Depr. Year MACRS Factor 3396 Espense $188.100 End-of-Year Book Value $381.900 39.900 1006 Year 1 Year 3 Cash Flow Statements: Year Unit price Unit sales Revenues 425,000 425.000 $ 850,000 Operating costs Depreciation Other project effects Before tax income Taxes Net income Plus depreciation Net op cash fow 850,000 637,500 188.100 20.000 $ 4,400 1.760 $ 2,640 188.100 $190.740 xxx ***@****/ **** ******** 637,500 39,900 20,000 $ 152,600 61.040 $ 91,560 39.900 $ 131,460 $ 100.000 Salvage value SV tax Recovery of NWC Termination CF Project NCF X QUESTIONS 1. Defne the term "incremental cash fow." Since the project will be fnanced in part by debt, should the cash fow statement include interest expenses? Explain. Yes. az the interest egove wil affect the anschthon 2. Should the $100,000 that was spent to rehabilitate the plant be included in the analysis? Explain. 3. (a) 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? 3. (b) The new project will lower sales of existing regular orange juice by $40,000 p.a., but reduces its production costs by $20,000 p.a. Should the net cannibalization effect of $20,000 p.a. be included in the analysis? 4. What is Indian River's Year 0 net investment outlay on this project? What is the expected nonoperating cash fow when the project is terminated at Year 4? (Hint: Use Table 1 as a guide.) 5. Estimate the project's operating cash fows. (Hint: Again use Table 1 as a guide.) What are the project's NPV, IRR, modif ed IRR (MIRR), and payback? Should the project be under- taken? [Remember: The MIRR is found in three steps: (1) compound all Cash Flow Estimation 12 INDIAN RIVER CITRUS COMPANY (A) Indian River Citrus Company is a leading producer of fresh, frozen, and made-from-concentrate citrus drinks. The firm was founded in 1929 by Matthew Stewart, a navy veteran who settled in Miami her World War I and began selling real estate. Since real estate sales were booming. Stew art's fortunes soured. His investment philosophy, which he proudly displayed behind his desk, was "Buy land. They aren't making any more of it." He practiced what he preached, but instead of invest ing in residential property, which he knew was grossly overvalued, he invested most of his sales commissions in citrus land located in Florida's 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 with several 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 United States. Indian River's management is currently evaluating a new product lite orange juice. Studies done by the firm's marketing department indicate that many people who like the taste of orange juic will not drink it because of its high caloric count. The new product would cost more, but it would offer consumers something that no other competing orange juice product offers 35 percent less Calories. Lili Romero and Brent Gibbs, recent business school graduates who are now working at the firm as financial analysts, must analyze this project, along with two other potential investments, and then present their findings to the company's executive committee Production facilities for the lite orange juice product would be set up in an unused section of Indian River's main plant. Relatively inexpensive, used irachinery with an estimated cost of only $500.000 would be purchased, but shipping costs to move the machinery to Indian River's plant would total $20,000, and installation charges would add another $50,000 to the total equipment cost. Further, Indian River's inventories fraw materials, work-in-process, and finished goods) would have to be icreased by $10.000 at the time of the initial investment. The machinery has a remaining Medways econic life of 4 years, and the company has obtained a special tax ruling that allows it to depre- ciate the equipment under the MACRS 3-year class. Under current tax law, the depreciation allowances are 0.33.0.45.0.15 and 0.07.in Years 1 through 4, respectively. The machinery is expected to have a salvage value of $100,000 after 4 years of use. The section of the main plant where the lite orange juice production would occur has been unused for several years, and consequently it has suffered some deterioration. Last year, as part of a routin-cilities improvement program, Indian River spent $100,000 to rehabilitate that section of the plant. Brent believes that this outlay, which has already been paid and expensed for tax pur. poses, should be charged to the lite orange juice project. His contention is that if the rehabilitation forlify Copyright 1994. The Dryden Press. All rights reserved Case: 12 Cash Flow Estimation had not taken place, the firm yould have to spend the $100,000 to make the site suitable for the range juice, production Indian River's management expects to sell 425,000 16-ounce care of the new orange juice product in each of the next 4 years at a price of $2.00 por caden, of which 51.50 per non would be needed to cover fredavanable cash operating costs. Since most of the cast are variable, the fxed 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 concern that the lite orange juice project would cut into the fm's sales of regular orange juice this type of effect is called cannibalization. Specifically, the sales man- ager estimated that regular orange juice sales would fall by 5 percent if lite orange juice were intro duced. 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 S40,000 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 $10,000+ $20,000 -$20,000. Indian River's federal-plus-state tax rate is 40 percent, and its overall cost of capital is 10 percent, calcu lated as follows: WACC - wkd(1-T) + wsks -0.5(10%X0.6) +0.5(14%) - 10.0% Lili and Brent were asked to analyze this project, along with two other projects, and then to present their findings in a "tutorial manner to Indian River's executive committee. The financial vice president, Lil and Brent's supervisor, wants them to educate some of the other executives, espe cially 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. Specifes on the other two projects that must be analyzed are provided in Questions 9 and 10. QUESTIONS I Defne the term incremental cash fow." Since the project will be fnanced in part by debt, should the cash fow statement include interest expenses? Explain. Y 02 e fect 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? 3. (b) The new project will lower sales of existing regular orange juice by S40,000 p.a., but reduces its production costs by 320,000 p.a. Should the nel Cannibalization effect of $20,000 p.a. be included in the analysis? 4. What is Indian River's Year Onet investment outlay on this project? What is the expected nonoperating cash row when the project is terminated a Year 47 (Hint: Use Table as a guide.) 5. Estimate the project's operating cash fows. (Hint: Again use Table I as a guide.) What are the project's NPV, IRR, modif ed IRR (MIRR), and payback? Should the project be under taken? [Remember: The MIRR is found in three steps: (1) compound all Case: 12 Cash Flow Estimation cash infows forward to the terminal year at the cost of capital. (2) sumn the compounded cash infows to obtain the terminal value of the infows, and (3) fnd 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 defned as the MIRR.] 6. Now suppose the project had involved replacement rather than expansion of existing facilities. Describe bricfy how the analysis would have to be changed to deal with a replacement project. 7. Assume that infation is expected to average 5 percent per year over the next 4 years. a. Does it appear that the project's cash fow estimates are real or nominal? That is, are the cash fows stated in constant (current year) dollars, or has infation been built into the cash fow estimates? (Hint: Nominal cash fows include the effects of infation, but real cash fows 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 infation 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 fxed by long-term contracts. For simplicity, assume that no other cash fows (net externality costs, salvage value, or net working capital) are affected by infation. What are the project's NPV, IRR, MIRR, and pay- back now that infation has been taken into account? (Hint: The Year I cash fows, as well as succeeding cash fows, must be adjusted for infation because the original estimates are in Year 0 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 rows are set forth as follows: Year Expected Net Cash Flow Projects ($100,000) 60,000 60,000 Project L ($100,000) 33,500 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 indefnitely into the future. Also, cach 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 Sin 2 years is estimated to be $105,000 because of infationary 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? C 12 Cash Flow Bima 10. The third project to be considered involves afect of delivery trucks with an engineering life of 3 years that is cach truck will be totally worn after years. However, if the trucks were taken out of service, or "abandoned prior to the end of years, they would have post tive salvage values. Here are the estimated net cash fows for each track End-of-Year Net Abandonment Cash Flow Year Initial Investment and Operating Cash Flow (S40,000) 16.800 16.000 14.000 24 DO 16.000 The relevant cost of capital is again 10 percent. 2. What would the NPV be if the trucks were operated for the full 3 years? b. What if they were abandoned at the end of Year 2? What if they were abandoned at the end of Year 1% c. What is the economic life of the track project! 11. Refar back to the orig i ne enange juice project. In this sad the remaining question quality your answering the Excel spreadsheet model 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 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 project's profitability under these conditions? 12. Return to the initial inflation assumptions (5 percent on price and 2 percent on cash operate ing costs 2. Assume that the sales quantity estimate remains at 425,000 units per year. What Year unit price would the company have to set to cause the project to just break even, that is, to force NPV-50? b. Now assume that the sales price remains at $2. What annual unit sales volume would be needed for the project to break even? Cases 12 Cash Flow Botimation TABLE 1 Project Cash Flow Estimates Depreciation Schedule: Basis Net Investment Outlay Price Freight Installation Change in NWC Depr. Year MACRS Factor 3396 Espense $188.100 End-of-Year Book Value $381.900 39.900 1006 Year 1 Year 3 Cash Flow Statements: Year Unit price Unit sales Revenues 425,000 425.000 $ 850,000 Operating costs Depreciation Other project effects Before tax income Taxes Net income Plus depreciation Net op cash fow 850,000 637,500 188.100 20.000 $ 4,400 1.760 $ 2,640 188.100 $190.740 xxx ***@****/ **** ******** 637,500 39,900 20,000 $ 152,600 61.040 $ 91,560 39.900 $ 131,460 $ 100.000 Salvage value SV tax Recovery of NWC Termination CF Project NCF X