Question

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 juice will not drink it because of its high calorie count. The new product would cost more, but it would offer consumers something that no other competing orange juice product offers—35percent 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. Although no one has expressed an interest in this portion of the plant, management wants to know how the analysis could incorporate the interest of another citrus in leasing the lite orange juice production site for $25,000 a year. Relatively inexpensive, used machinery with an estimated cost of only $600,000 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 (raw materials, work-in-process, and finished goods) would have to be increased by $10,000 at the time of the initial investment. The machinery has a remaining economic life of four years, and the company has obtained a special tax ruling that allows it to depreciate the equipment under the MACRS 3-year class. Under current tax law, the depreciation allowances are 0.33, 0.45, 0.15, and0.07 in Years 1 through 4, respectively. The machinery is expected to have a salvage value of$100,000 after four 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 routine facilities 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 purposes, should be charged to the lite orange juice project. His contention is that if the Case 12 Indian River Citrus Company (A)Capital Budgeting Directed rehabilitation had not taken place, the firm would have to spend the $100,000 to make the site suitable for the orange juice production line.

Indian River’s management expects to sell 425,000 16-ounce cartons of the new orange juice product in each of the next four years, at a price of $3.00 per carton, of which $1.50 per carton would be needed to cover fixed and variable cash operating costs. Since most of the costs are variable, the fixed 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 firm’s sales of regular orange juice—this type of effect is called cannibalization. Specifically, the sales manager estimated that regular orange juice sales would fall by 5 percent if lite orange juice were introduced. 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 $40,000 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 -$40,000 + $20,000 = -$20,000. Indian River’s federal-plus-state tax rate is 40 percent, and with a 10 percent cost of debt and a 14 percent cost of equity, its overall cost of capital is 10 percent, calculated as follows:

WACC=wdkd1-T+ wsks

=0.510%(1-.4)+0.5(14%)

=10.0%

Lili and Brent were asked to analyze this project, along with two other projects discussed below, and then to present their findings in a “tutorial” manner to Indian River’s executive committee. They were also asked to extend their original presentation to explain how inflation of 5percent per year over the next four years would impact the analysis and how the analysis would change if the decision had been to replace an existing machine rather than to expand an existing facility.

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 flows are set forth below:

Expected Net Cash Flow Year Project S Project

Year	Project S	Project L
0	($100,000)	($100,000)
1	60,000	33,500
2	60,000	33,500
3	-	33,500
4	-	33,500

Both of these projects are in Indian River’s main line of business and have average risk, hence each is assigned the 10 percent corporate cost of capital. The investment, which is chosen, is expected to be repeated indefinitely into the future. Lili and Brent are concerned about inflationary pressures. Therefore, they believe it would be useful to also assume that the cost to replicate Project S in two years is estimated to be $105,000 and similar investment cost increases would occur for both projects in Year 4 and beyond.

The third project to be considered involves a fleet of delivery trucks with an engineering life of three years (that is, each truck will be totally worn out after three years). However, if the trucks were taken out of service, or “abandoned,” prior to the end of three years, they would have positive salvage values. Here are the estimated net cash flows for each truck:

Year	Initial Investment and Operating Cash Flow	End of Year Net Abandonment Cash Flow
0	(40,000)	40,000
1	16,800	24,800
2	16,000	16,000
3	14,000	0

Given the relevant cost of capital is again 10 percent, Lili and Brent have been asked to analyze the NPV over the trucks full 3 years of operation as well as earlier abandonment. The financial vice president, Lili and Brent’s supervisor, wants them 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, Lili and Brent have decided to ask and then answer a series of questions as set forth below.

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

Answer 1

THE PROJECT HAD INVOLVED REPLACEMENT RATHER THAN EXPANSION OF EXISTING FACILITIES.BECAUSE THE REPLACEMENTS EXPECTED NET CASH FLOW YEAR PROJECT ‘S’ SHOULD COMES TOTAL OF 1,20,000/- FOR $1,00,000/-. THAT IS LESS THAN THE EXPECTED NET CASH FLOW YEAR PROJECT ‘L’. IT WILLCOME AROUND $1,34,000/- FOR $1,00,000/-.

THEY BELIEVE IT WOULD BE USEFUL TO ALSO ASSUME THAT THE COST TO REPLICATE PROJECT ‘S’ IN TWO YEARS IS ESTIMATED TO BE $105,000 AND SIMILAR INVESTMENT COST INCREASES WOULD OCCUR FOR BOTH PROJECTS IN YEAR 4 AND BEYOND. BOTH OF THESE PROJECTS ARE IN INDIAN RIVER’S MAIN LINE OF BUSINESS AND HAVE AVERAGE RISK, HENCE EACH IS ASSIGNED THE 10 PERCENT CORPORATE COST OF CAPITAL. THE INVESTMENT, WHICH IS CHOSEN, IS EXPECTED TO BE REPEATED INDEFINITELY INTO THE FUTURE. THE THIRD PROJECT TO BE CONSIDERED INVOLVES A FLEET OF DELIVERY TRUCKS WITH AN ENGINEERING LIFE OF THREE YEARS THE TRUCKS WERE TAKEN OUT OF SERVICE, OR “ABANDONED,” PRIOR TO THE END OF THREE YEARS, THEY WOULD HAVE POSITIVE SALVAGE VALUES.