Triton Bakery Capital Budgeting

Jenny is thinking about ways to automate more of her baking operation to both accommodate the increase in demand for the cookies and reduce the labor costs of her operation. Labor has become much harder to find these days and, as a result is much more expensive. Jenny is evaluating three projects: an automated mixer, a continuous baking oven, and a semi-automated packing unit.

BACKGROUND

Jenny founded Triton Bakery in 2005, who moved to the community looking for work. During the summer months, work had been easy to find because of tourists who were coming in increasing numbers for a vacation. During the winter months, however, there was not much work, so Jenny started a small bakery business from her home, baking butter cookies. The business grew until she bought a small piece of property in the city and opened that areas only bakery. Currently the bakery serves the community of about 15,000 people with fresh baked goods, plus the bakery has a large and growing mail-order business, shipping cookies all over Hong Kong and China.

The mail-order business is due to the popularity of their butter cookie, which has a very long shelf life and will stay fresh and tasty for almost one year. The cookie business fits nicely with the huge increase in demand for fresh pastries that occurs with the influx of vacationers in the summer. The high demand for cookies occurs during Chinese New Year, Mid-autumn and Christmas seasons, giving the bakery time to build up an inventory of cookies before the peak demand. For examples, during the peak Chinese New Year period, as many as four SF Express trucks per day will be filled with cookies. The company prides itself on shipping any order that arrives before 3pm on that same day. During the off-season, any order that arrives by 5pm will be shipped that same day. The bakery has about 100 full-time employees.

The shares of Triton Bakery are traded over the counter and currently have a market price of $27 per share. This year the company paid dividend of $1.215 per share. Earnings and dividends have been growing at a constant rate of 8% annually for the past 10 years and are expected to continue to maintain this growth rate into the foreseeable future. The firm has one bond outstanding, a mortgage bond with 8% coupon, which pays interest semi-annually, with 10 years until it matures. This bond is currently selling at a discount and is quoted at $875. The marginal tax rate for Triton Bakery is 35%.

Below is partial balance sheet:

Triton Bakery Balance Sheet as of Dec. 31
Current liabilities	$1,000,000
Mortgage Bond	5,143,000
Common Stock (500,000 shares outstanding)	500,000
Contributed capital in excess of par	2,000,000
Retained Earnings	8,640,210
Total liabilities & common equity	$17,283,210

Production Process

Although the fresh bakery business has stabilized over the past five years, Triton Bakery has seen a tremendous increase in the demand for its cookies, most of which are mail orders. The method of making cookies is known to almost every one and making cookies at Triton Bakery is not much different from baking cookies at home; just the scale is different. But Jenny uses a secret recipe that has been handed down through the generations. Today, only two family members know the recipe.

First the ingredients are mixed in a large stainless-steel bowl and then the dough is cooled in a large walk-in cooler. Next, the dough is rolled out on a marble counter, with a rolling pin, and then the cookie is cut out with a cookie cutter. The cookie is then place on a baking tray and the trays are placed in a rolling bin that holds 20 trays. The bins are then rolled into a gas-fired oven that accommodates two bins. The cookies are baked at 360 degrees for 20 minutes and then rolled into a cooling area. The cookies are allowed to cool over a 24-hour period to room temperature. The final step in the process is to wrap the cookies and place them in one-pound tins or half-pound tubes.

As part of the planning for the coming year, Jenny is evaluating three pieces of equipment: an automated mixer, a continuous baking oven, and a semi-automated baking unit. She plans to consider each a separate project to be evaluated on its own merit, that is, each is an independent project.

Taking into consideration her expected earnings and her borrowing capacity, Jenny thinks she can commit up to $1,000,000 to capital projects this year.

Automated mixer

To replace an old mixer, Jenny is considering a new automated mixer that will increase the amount of cookie dough that can be mixed by 500 pounds per day. The new mixer will cost $240,000 installed. The older mixer has been fully depreciated and has no market value, but it will be retained as a backup or for extra capacity if needed. The new mixer is expected to increase revenues by $62,500 per year and to decrease expenses by $22,500 per year. Both revenues and expenses are expected to increase 5% each year. The new mixer will be depreciated on a three-year MACRS, which assumes that the half-year convention applies, to a salvage value of zero. The anticipated salvage value at the end of the five-year economic life of the mixer is also zero. Jenny expects to replace the mixer at the end of five years. The increased production of cookies can be easily stored in an unused portion of the warehouse. With the installation of the new equipment, Jenny has determined that the value of the average increase in cookies stored in the warehouse will be about $16,000, accounts receivable will increase $4,000, and accounts payable will increase about $6,000. This figures should increase with the installation of the mixer.

Baking Oven

Jenny is also evaluating a continuous baking oven. The new oven would cost $685,000, which includes cost of the equipment, shipping and installation. The installation costs include some minor changes in the current production layout to accommodate the most efficient use of the continuous oven. Triton Bakery currently uses six large upright ovens that are loaded from the front end with two large roll-in racks that contain twenty cookie trays each. A continuous oven would allow the cookie trays to be placed directly on a roller belt that feeds directly to the oven. The oven would replace the six roll-in ovens that are currently being used. Although there would be no increase in capacity, Jenny has calculated that the new oven would result in a savings in operating expenses of $105,000 per year. The oven would be depreciated on a seven-year MACRS schedule to a value of zero, although Jenny believes she can sell the oven for $30,000 in 10 years. She also expects that these expenses would have increase at least 5% per year over the 10-year economic life of the oven.

Semi-automated Packing Unit

The final project that Jenny is considering is a semi-automated packing unit that would cost $390,000 including installation. The new packing unit that would be depreciated on a seven-year MACRS schedule. The economic life of the packer is 10 years, at which time the unit would have no market value. Currently Triton Bakery has a wrapping machine which was purchased four years ago for $90,000 and was being depreciated on a seven-year MACRS schedule. The wrapper has a current market value of $20,000. The packing unit will result in a savings in operating expenses of $90,000 per year. These expenses are expected to increase 5% per year over the ten-year economic life of the unit.

Depreciation Rates for MACRS Property
Year	3-year	7-year
1	33.33%	14.29%
2	44.45	24.49
3	14.81	17.49
4	7.41	12.49
5		8.93
6		8.92
7		8.93
8		4.46

Details of the calculations for below questions:

Calculate the yield-to-maturity for the mortgage bond.

Estimate the cost of equity.

What is the firms overall cost of capital?

Find the net cash flows for the automated mixer.

Calculate the NPV for the automated mixer project.

What is the IRR for the mixer?

Determine the NPV of the continuous baking oven.

Determine the NPV of the semi-automated packing unit.

Which capital projects should Mike undertake this year?