Robert Montoya, Inc., is a leading producer of wine in the United States. The firm was founded in 1960 by Robert Montoya, an Air Force veteran who had spent several years in France both before and after World War II. This experience convinced him that California could produce wines that were as good as or better than the best France had to offer. Originally, Robert Montoya sold his wine to wholesalers for distribution under their own brand names. Then in the early 1960s, when wine sales were expanding rapidly , he joined with his brother Marshall and several other producers to form Robert Montoya, Inc., which then began an aggressive promotion campaign. Today, its wines are sold throughout the world.

The table wine market has matured and Robert Montoyas wine cooler sales have been steadily decreasing. Consequently, to increase winery sales, management is currently considering a potential new product: a premium varietal red wine using the cabernet sauvignon grape. The new wine is designed to middle-to-upper-income professionals. The new product, Suave Mauve, would be positioned between the traditional table wines and super premium table wines. In market research samplings at the companys Napa Valley headquarters, it was judged superior to various competing products. Sarah Sharpe, the financial vice president, must analyze this project, and then present her findings to the companys executive committee.

Production facilities for the new wine would be set up in unused section of Robert Montoyas main plant. New machinery with an estimated cost of $2,200,000 would be purchased, but shipping costs to move the machinery to Robert Montoyas plant would total $80,000, and installation charges would add another $120,000 to the total equipment cost. Furthermore, Robert Montoyas inventories (the new product requires aging for 5 years in oak barrels made in France) would have to be increased by $100,000. This cash flow is assumed to occur at the time of the initial investment. The machinery has a remaining economic 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 1 through 4 respectively. The machinery is expected to have a salvage value of $150,000 after 4 years of use.

The section of the plant in which production would occur had not been used for several years and, consequently, had suffered some deterioration. Last year, as part of a routine facilities improvement program, $300,000 was spent to rehabilitate that section of the main plant. Earnie Jones, 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 $300,000 to make the plant suitable for the wine project.

Robert Montoyas management expects to sell $100,000 bottles of the new wine in each of the next 4 years, at a wholesale price of $40 per bottle, but $32 per bottle would be needed to cover cash operating costs. In examining the sales figures, Sharpe noted a short memo from Robert Montoyas sales manager which expressed concern that the wine project would cut into the frims sales of other wines this type of effect is called cannibalization. Specifically, the sales manager estimated that existing wine sales would fall by 5 percent if the new wine were introduced. Sharpe then talked to both the sales and production managers and concluded that the new project would probably lower the firms existing wine sales by $60,000 year, but, at the same time, it would also reduce production costs by $40,000 per year, all on a pre-tax basis. Thus, the net externality effect would be -$60,000 + $40,000 = -$20,000. Robert Montoyas federal-plus-state tax rate is 40 percent, and its overall cost of capital is 10 percent, calculated as follows:

WACC = W_d k_d (1 T) + W_s k_s

= 0.5 (10%)(0.6)+0.5(14%)

= 10%

Now assume that you are Sharpes assistant and she has asked you to analyze this project, along with two other projects, and then to present your findings in a tutorial manner to Robert Montoyas executive committee. As financial vice president. Sharpe wants 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, Sharpe wants you to ask and then answer a series of questions as set forth next. Keep in mind that you will be questioned closely during your presentation, so you should understand every step of the analysis, including any assumptions and weaknesses that may be lurking in the background and that someone might spring on you in the meeting.

Questions:

4. What is Robert Montoyas Year 0 net investment outlay on this project? What is the expected no operating cash flow when the project is terminated at Year 4? (Hint: Use Table 1 as a guide)

5. Estimate the projects operating cash flows. (Hint: Again use Table 1as a guide) What are the projects NPV, IRR, modified IRR (MIRR), and payback? Should the project be undertaken?

6. Now suppose the projects had involved replacement rather than expansion of existing facilities. Describe briefly how the analysis has to be changed to deal with a replacement project.

7. A. Assume that inflation is expected to average 5 percent per year over the next 4 years. Does it appear that the projects cash flow estimates are real or nominal? That is are they 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?

10. The third project to be considered involves a fleet a trucks with an engineering life of 3 years (that is that truck will be totally worn out after 3 years). However, if the trucks were taking out of services, or abandoned, prior to the end of 3 years, they would have a positive salvage value. Here are the estimated net cash flows for each truck.

The relevant cost of capital is again 10 percent.

(a) What would be NPV be if trucks were operated for the full 3 years?

(b) What if they were abandoned at the end of the Year 2? What if they were abandoned at the end of the year 1?

(c) What is the economic life of the truck project?

Year Initial Investment End-of-Year Net

And Operating Cash Flow Abandonment Cash Flow

0 ($60,000) $60,000

1 25,200 37,200

2 24,000 24,000

3 21,000 0

Table 1

Price Freight	X X	Basic=	MACRS	X	Depr	End of Year
Installation	X	Year	Factor		Expense	Book Value
Change in NWC	X	1	33%		$792,000	1,608,000
	X	2	X		X	X
		3	X		X	X
		4	7		168,000	0
			100%		2,400,000