The Bluebell Dairy Company Pty Ltd (Bluebell) runs a well-established cheese making business near Scottsdale in beautiful North East Tasmania. The business includes three dairy farms, a cheese factory and a caf where a range of breakfast and lunch meals, snacks and deserts are served. The milk processed in the cheese factory is supplied from the company's dairy farms as well as from a few other local dairy farms. Bluebell is specialized in the production of English style Cheddar cheese of various maturity and flavour for which it has won several awards. Its reputation is based not only on the quality of its cheese, but also on the sustainable farming system adopted on its dairy farms and cheese production methods.

Bluebell sells some of its cheeses through its caf but the majority of its dairy products are sold on the mainland through fine food specialty shops and gourmet delicatessen.

Due to the growing popularity of its products, Bluebell is currently considering exporting some its production to the North American and European markets. This will require a significant expansion of its existing cheese factory. Bluebell's management is assessing the investment project and have asked you to provide them with some advice about the financial viability of the project and possible sources of financing.

The construction of the new cheese factory will take place over four months at the end of 2017. During the construction period, the existing cheese making facilities will not be affected and production of cheese and other dairy products will remained unchanged. However the caf will need to be closed for the duration of the construction. Sales from the caf over that period (from September to December 2017) are estimated at $120,000. Variable costs associated with the caf operation will not be incurred, however all fixed costs will remained unchanged.

The total costs of expansion are estimated at $1,250,000 this includes the cost of construction of the new building, all fittings and machinery. In addition to the actual building and machinery costs, Bluebell has budgeted $200,000 in marketing costs to establish its European and North American markets. It is also estimated that the increased activity will require the immediate injection of an additional $250,000 in working capital (assumed at 31/12/2017).

Bluebell is a proprietary company and the Board of directors is still unsure how the project should be funded. The main shareholders of the company are members of the founding family and most have indicated that they would be willing to contribute more equity to the company. The local bank with which Bluebell normally does business has given its in-principle agreement that it would be prepared to lend the company $600,000 over 5 years at a rate of 6%. The loan will be repaid by constant annual repayments payable at the end each year.

Judith, the company CFO would like you help her examine the viability of the project for the next five years given two scenarios: an optimistic scenario and a realistic (conservative scenario). Given the risk associated with the project, she believes it is reasonable to use a cost of capital of 10% for

the evaluation of this project. Further financial data relating to the project can be found in the appendix.

Your task

Based on this information in the case study and in the appendix, Judith has asked you to help with report to Bluebell's Board of Directors advising them as to the best course of action regarding this project. Your report should address the following specific questions from the board of directors:

1.Discuss which costs are relevant for the evaluation of this project and which costs are not. Your discussion should be justified by a valid argument and supported by references to appropriate sources.

Total costs of expansion: 1250000

Construction of new factory: 400000

Fittings: 200000

Machinery: 650000

Caf cost: 120000

Marketing costs: 200000

Working capital: 250000

Loan: 600000

Fixed costs of caf: 8000/month

Annual fixed costs of production +20% due to expansion: 400000*(1+0.2)

Administrative costs: 560000*(1+0.1)

Relevant costs:

Construction of new factory/fitting/machinery.

Caf costs

Loan

Annul fixed costs of production

Administrative costs

Non-relevant costs:

Operating costs,

Marketing costs,

Working capital,

http://accounting-simplified.com/management/relevant-costing/#types-of-relevant-cost

2.Estimate the depreciation costs (machinery and construction costs) associated with the project for each year for the period 2018- 2022. In your report you should justify the choice of a particular depreciation method over another.

depreciation:

Prime cost method: 1250000/15= 83333.33 (annual depreciation)

Diminishing value method: 1250000*(365/365)*(2/15)=166666.667 (first year)

(1250000-166666.667)*(2/15)=22222.222 (second year)

(1250000-166666.667-22222.22)*(2/15)=

https://www.ato.gov.au/business/depreciation-and-capital-expenses-and-allowances/general-depreciation-rules---capital-allowances/prime-cost-%28straight-line%29-and-diminishing-value-methods/

3.Estimate the relevant annual net operating cash flows associated with the project for the period 2017- 2022 under each of the two scenarios envisaged by the CFO. You will need to broadly describe the method used for determining those cash flows and indicate any assumption (s) that may have to make.

Where:

OCF_t = Operating cash Flow for year t

EBIT_t = Earnings Before Interest and Tax for year t (Operating Profit)

T_t= Tax expense for year t

D_t = Depreciation expense for year t

Note that interest expense is ignored when calculating OperatingCash Flows. This is because the cost of finance is implicitly taken into account in the discount rate. However Interest is tax deductible and should be taken into account in the calculation of tax.

4.Estimate the time when the initial investment will be paid back under each scenario. Assume in your calculation that working capital will be fully recovered at the end of the project but ignore the possible terminal value of other assets. Also ignore the time value of money. Briefly comment on your results.

5.Estimate the Net Present Value (NPV) of the project under each scenario assuming that the project is entirely funded by equity capital (Retained earnings and new share issue). Assume that annual cash flows are derived (or expended) at the end of each year. Also assume here that tangible assets (machinery + building) are worth $500,000 at the end of 2022 and that working capital is fully recovered. Briefly comment on your results and make appropriate remarks on the assumptions made for these calculations if necessary.

6.Assume now that Bluebell accepts the loan offer from the Bank and contributes the rest of the funds through equity contribution from existing shareholders. In the light of what was covered in your lecture and of your own research, briefly discuss whether the interest expense on the loan should be included in your cash flow estimates for the project.

7.Estimate the NPV of the project for each scenario under the above partial debt funding model? (use the same assumptions as in the fully equity case regarding annual cash flows and terminal value). Briefly comment on your results and compare with the results fromyour previous calculations. You may also wish to explain to the board of directors why the results differ or why they are similar.

8.Advise the board of directors as to whether they should go ahead with the investment project and if so, which funding model they should choose. In your recommendations, you maywish to suggest possible refinements in the method used for evaluating this project.

CASE STUDY The Bluebell Dairy Company Pty Ltd (Bluebell) runs a well-established cheese making business near Scottsdale in beautiful North East Tasmania. The business includes three dairy farms, a cheese factory and a caf where a range of breakfast and lunch meals, snacks and deserts are served. The milk processed in the cheese factory is supplied from the company's dairy farms as well as from a few other local dairy farms. Bluebell is specialized in the production of English style Cheddar cheese of various maturity and flavour for which it has won several awards. Its reputation is based not only on the quality of its cheese, but also on the sustainable farming system adopted on its dairy farms and cheese production methods. Bluebell sells some of its cheeses through its caf but the majority of its dairy products are sold on the mainland through fine food specialty shops and gourmet delicatessen. Due to the growing popularity of its products, Bluebell is currently considering exporting some its production to the North American and European markets. This will require a significant expansion of its existing cheese factory. Bluebell's management is assessing the investment project and have asked you to provide them with some advice about the financial viability of the project and possible sources of financing. The construction of the new cheese factory will take place over four months at the end of 2017. During the construction period, the existing cheese making facilities will not be affected and production of cheese and other dairy products will remained unchanged. However the caf will need to be closed for the duration of the construction. Sales from the caf over that period (from September to December 2017) are estimated at $120,000. Variable costs associated with the caf operation will not be incurred, however all fixed costs will remained unchanged. The total costs of expansion are estimated at $1,250,000 this includes the cost of construction of the new building, all fittings and machinery. In addition to the actual building and machinery costs, Bluebell has budgeted $200,000 in marketing costs to establish its European and North American markets. It is also estimated that the increased activity will require the immediate injection of an additional $250,000 in working capital (assumed at 31/12/2017). Bluebell is a proprietary company and the Board of directors is still unsure how the project should be funded. The main shareholders of the company are members of the founding family and most have indicated that they would be willing to contribute more equity to the company. The local bank with which Bluebell normally does business has given its in-principle agreement that it would be prepared to lend the company $600,000 over 5 years at a rate of 6%. The loan will be repaid by constant annual repayments payable at the end each year. Judith, the company CFO would like you help her examine the viability of the project for the next five years given two scenarios: an optimistic scenario and a realistic (conservative scenario). Given the risk associated with the project, she believes it is reasonable to use a cost of capital of 10% for the evaluation of this project. Further financial data relating to the project can be found in the appendix. Your task Based on this information in the case study and in the appendix, Judith has asked you to write a report to Bluebell's Board of Directors advising them as to the best course of action regarding this project. Your report should address the following specific questions from the board of directors: 1. Discuss which costs are relevant for the evaluation of this project and which costs are not. Your discussion should be justified by a valid argument and supported by references to appropriate sources. 2. Estimate the depreciation costs (machinery and construction costs) associated with the project for each year for the period 2018- 2022. In your report you should justify the choice of a particular depreciation method over another. 3. Estimate the relevant annual net operating cash flows associated with the project for the period 2017- 2022 under each of the two scenarios envisaged by the CFO. You will need to broadly describe the method used for determining those cash flows and indicate any assumption (s) that may have to make. 4. Estimate the time when the initial investment will be paid back under each scenario. Assume in your calculation that working capital will be fully recovered at the end of the project but ignore the possible terminal value of other assets. Also ignore the time value of money. Briefly comment on your results. 5. Estimate the Net Present Value (NPV) of the project under each scenario assuming that the project is entirely funded by equity capital (Retained earnings and new share issue). Assume that annual cash flows are derived (or expended) at the end of each year. Also assume here that tangible assets (machinery + building) are worth $500,000 at the end of 2022 and that working capital is fully recovered. Briefly comment on your results and make appropriate remarks on the assumptions made for these calculations if necessary. 6. Assume now that Bluebell accepts the loan offer from the Bank and contributes the rest of the funds through equity contribution from existing shareholders. In the light of what was covered in your lecture and of your own research, briefly discuss whether the interest expense on the loan should be included in your cash flow estimates for the project. 7. Estimate the NPV of the project for each scenario under the above partial debt funding model? (use the same assumptions as in the fully equity case regarding annual cash flows and terminal value). Briefly comment on your results and compare with the results from your previous calculations. You may also wish to explain to the board of directors why the results differ or why they are similar. 8. Advise the board of directors as to whether they should go ahead with the investment project and if so, which funding model they should choose. In your recommendations, you may wish to suggest possible refinements in the method used for evaluating this project. APPENDIX: Additional information for the case Caf data Variable costs associated with the operation of the caf represent 40% of sales Fixed costs for the cafe are estimated at $8,000 per month Caf would be closed from 1 September 2017 until the end of 2017 Cost of expansion The $1,250,000 estimated costs of expansion can be broken down as follows: Construction of new factory: $400,000 Fittings: $200,000 Machinery: $650,000 For tax purposes, the machinery and fittings may be depreciated using either the prime cost or the diminishing value methods as set out in Division 40 of the Income tax Assessment Act (ITAA) 1997. The recommended life for assets used for cheese manufacturing is 15 years. (Tax Ruling 2017/2; Table A: industry categories). Judith indicated to you that the company will retain the method that is the most advantageous from a tax point of view, i.e. the depreciation method that maximizes its tax deductions. The construction expenditure of the factory may be depreciated for tax purposes at a rate of 4% per annum (Section 43-210 of ITAA1997) (only the prime cost method is available in this case). Marketing costs The $200,000 marketing costs associated with the expansion of the market will be incurred as follows: $50,000: during the last part of 2017 $50,000 in 2018 $25,000 for each of the following 4 years These costs are fully tax deductible in the year they are incurred (assume calendar year). Sales projections Projections regarding additional annual sales of cheese from the expanded production over the next five years are as follows: 2018 2019 2020 2021 2022 Conservative scenario ($) 700,000 900,000 1,000,000 1,100,000 1,100,000 Optimistic scenario ($) 800,000 1,000,000 1,100,000 1300000 1,300,000 Operating costs Operating variable costs associated with the production of cheese are equal to 50% of the sale value of production. Existing annual fixed costs of production (excluding depreciation) are $400,000. As a result of the expansion these costs will increase by 20%. Existing administrative costs are $560,000 per annum. These costs will only increase by 10% as a result of the expansion. Tax rate The company is subject to a tax rate of 27.5%. Solution 1. Total costs of expansion: 1250000 Construction of new factory: 400000 Fittings: 200000 Machinery: 650000 Caf cost: 120000 Marketing costs: 200000 Working capital: 250000 Loan: 600000 Fixed costs of caf: 8000/month Annual fixed costs of production +20% due to expansion: 400000*(1+0.2) Administrative costs: 560000*(1+0.1) Relevant costs: Construction of new factory/fitting/machinery. Caf costs Loan Annul fixed costs of production Administrative costs Non-relevant costs: Operating costs, marketing costs, working capital, http://accounting-simplified.com/management/relevant-costing/#types-of-relevant-cost 2. depreciation: https://www.ato.gov.au/business/depreciation-and-capital-expenses-and-allowances/generaldepreciation-rules---capital-allowances/prime-cost-%28straight-line%29-and-diminishing-valuemethods/ 3