Case study: This case is intended to be an introduction to the various methods used in capital budgeting and looks at some of the decisions that may have to be made when evaluating projects. It is also designed to develop skills in using spreadsheets. You should set up a spreadsheet at the start to help analyse the problems.
When using a spreadsheet, any tables that you wish to present to the reader should be embedded into a Word document as an ordinary table. Note, however, that you must still show how an answer is obtained, for example, you must show in Q5 how the NPV was derived, not simply give the final answer.
Archer Juices, Inc
Archer Juices is a leading juice producer who distributes unfranked dividends to its shareholders. The firm was founded in 1968 by Charles Archer who had spent several years in Australia and who was convinced that his country could produce juices that were as good as or better than the best Australia had to offer. Originally, Archer sold his juice to wholesalers for distribution under their brand names, but in the early 1970s, when juice sales were expanding rapidly, he joined with several other producers to form Archer Juices, which then began an aggressive promotion campaign. Today, its juices are sold throughout the country.
Archer's management is currently evaluating a potential new product; a light, fruity juice designed to appeal to the younger generation. The new product, Bulgong Gold, would be positioned between the various juice coolers and the traditional drinks. The new product would cost more than juice coolers, but less than premium table drinks, and in market research samplings at the company's Bulgong headquarters, it was judged superior to various competing products. Jan Armstrong, the Chief Financial Officer, must analyse this project, along with other potential investments, and then present her findings to the company's executive committee.
Production facilities for the new juice product would be set up in an unused section of Archer's main plant. Relatively inexpensive, used machinery with an estimated cost of only $500,000 would be purchased, but shipping costs to move the machinery to Archer's plant would total $40,000, and installation charges would add another $60,000 to the total equipment cost. Further, Archer's inventories would have to be increased by $20,000, and 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 country’s Tax Office ruling will allow Archer Juices to claim the following annual depreciation allowances:
. . .Year 1: 33% . . .Year 2: 45% . . .Year 3: 15% . . .Year 4: 7%
The machinery is expected to have a salvage value of $50,000 after 4 years of use.
The section of the plant in which production would occur has not been used for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, Archer spent $200,000 to rehabilitate that section of the main plant. Rufus Smith, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the juice project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $200,000 to make the site suitable for the juice project.
Archer's management expects to sell 200,000 bottles of the new juice product in each of the next 4 years, at a wholesale price of $4 per bottle, but $3 per bottle would be needed to cover fixed and variable cash operating costs. In examining the sales figures, Armstrong noted a short memo from Archer's sales manager which expressed concern that the juice project would cut into the firm's sales of juice coolers - this type of effect is called an externality (or opportunity cost). Specifically, the sales manager estimated that juice cooler sales would fall by 5 percent if the new juice were introduced. Armstrong then talked to both the sales and production managers, and she concluded that the new project would probably lower the firm's juice cooler sales by $40,000 per year, but, at the same time, it would also reduce production costs for this product by $20,000 per year, all on a pre-tax basis. Thus, the net externality effect would be -$40,000 + $20,000 = -$20,000.
Archer's effective tax rate is 40 percent, and its overall cost of capital is 10 percent, WACC = 10%
Question 1 (10 marks)
a. Define the term 'incremental cash flow'. Since the project will be financed in part by debt, should the cash flow statement include interest expenses? Explain.
b. Should the $200,000 that was spent to rehabilitate the plant be included in the analysis? Explain.
c. Suppose another juice maker had expressed an interest in leasing the wine production site for $10,000 a year. If this were true (in fact it was not), how should that information be incorporated into the analysis?
Question 2 (15 marks)
Using Tables 1 and 2 to help identify relevant cash flows, what are the projects:
a. Net Present Value (NPV)
b. Internal Rate of Return (IRR)
c. Payback Period
d. Will you recommend that the project should be undertaken? Why or why not?
Question 3 (5 marks)
Now assume that the sales price will increase by the 5% inflation rate beginning after Year 0. However, assume also that operating costs will increase by only 2% annually from the initial cost estimate, because over half of the costs are fixed by long-term contracts. For simplicity, assume that no other cash flows (net externality costs, salvage value, or net working capital) are affected by inflation. What are the project's NPV, IRR and Payback Period now that inflation has been taken into account? Does change your recommendation in Q2 (d)? (Hint: the Year 1, and succeeding cash flows, must be adjusted for inflation because the estimates are in Year 0 dollars.)
When using a spreadsheet, any tables that you wish to present to the reader should be embedded into a Word document as an ordinary table. Note, however, that you must still show how an answer is obtained, for example, you must show in Q5 how the NPV was derived, not simply give the final answer.
Archer Juices, Inc
Archer Juices is a leading juice producer who distributes unfranked dividends to its shareholders. The firm was founded in 1968 by Charles Archer who had spent several years in Australia and who was convinced that his country could produce juices that were as good as or better than the best Australia had to offer. Originally, Archer sold his juice to wholesalers for distribution under their brand names, but in the early 1970s, when juice sales were expanding rapidly, he joined with several other producers to form Archer Juices, which then began an aggressive promotion campaign. Today, its juices are sold throughout the country.
Archer's management is currently evaluating a potential new product; a light, fruity juice designed to appeal to the younger generation. The new product, Bulgong Gold, would be positioned between the various juice coolers and the traditional drinks. The new product would cost more than juice coolers, but less than premium table drinks, and in market research samplings at the company's Bulgong headquarters, it was judged superior to various competing products. Jan Armstrong, the Chief Financial Officer, must analyse this project, along with other potential investments, and then present her findings to the company's executive committee.
Production facilities for the new juice product would be set up in an unused section of Archer's main plant. Relatively inexpensive, used machinery with an estimated cost of only $500,000 would be purchased, but shipping costs to move the machinery to Archer's plant would total $40,000, and installation charges would add another $60,000 to the total equipment cost. Further, Archer's inventories would have to be increased by $20,000, and 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 country’s Tax Office ruling will allow Archer Juices to claim the following annual depreciation allowances:
. . .Year 1: 33% . . .Year 2: 45% . . .Year 3: 15% . . .Year 4: 7%
The machinery is expected to have a salvage value of $50,000 after 4 years of use.
The section of the plant in which production would occur has not been used for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, Archer spent $200,000 to rehabilitate that section of the main plant. Rufus Smith, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the juice project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $200,000 to make the site suitable for the juice project.
Archer's management expects to sell 200,000 bottles of the new juice product in each of the next 4 years, at a wholesale price of $4 per bottle, but $3 per bottle would be needed to cover fixed and variable cash operating costs. In examining the sales figures, Armstrong noted a short memo from Archer's sales manager which expressed concern that the juice project would cut into the firm's sales of juice coolers - this type of effect is called an externality (or opportunity cost). Specifically, the sales manager estimated that juice cooler sales would fall by 5 percent if the new juice were introduced. Armstrong then talked to both the sales and production managers, and she concluded that the new project would probably lower the firm's juice cooler sales by $40,000 per year, but, at the same time, it would also reduce production costs for this product by $20,000 per year, all on a pre-tax basis. Thus, the net externality effect would be -$40,000 + $20,000 = -$20,000.
Archer's effective tax rate is 40 percent, and its overall cost of capital is 10 percent, WACC = 10%
Question 1 (10 marks)
a. Define the term 'incremental cash flow'. Since the project will be financed in part by debt, should the cash flow statement include interest expenses? Explain.
b. Should the $200,000 that was spent to rehabilitate the plant be included in the analysis? Explain.
c. Suppose another juice maker had expressed an interest in leasing the wine production site for $10,000 a year. If this were true (in fact it was not), how should that information be incorporated into the analysis?
Question 2 (15 marks)
Using Tables 1 and 2 to help identify relevant cash flows, what are the projects:
a. Net Present Value (NPV)
b. Internal Rate of Return (IRR)
c. Payback Period
d. Will you recommend that the project should be undertaken? Why or why not?
Question 3 (5 marks)
Now assume that the sales price will increase by the 5% inflation rate beginning after Year 0. However, assume also that operating costs will increase by only 2% annually from the initial cost estimate, because over half of the costs are fixed by long-term contracts. For simplicity, assume that no other cash flows (net externality costs, salvage value, or net working capital) are affected by inflation. What are the project's NPV, IRR and Payback Period now that inflation has been taken into account? Does change your recommendation in Q2 (d)? (Hint: the Year 1, and succeeding cash flows, must be adjusted for inflation because the estimates are in Year 0 dollars.)
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