Question

Carly’s Winery was founded 10 years ago by owner manager Carla. Carly’s Winey is buying wines from wholesalers and sell them to retailers. Carla decided to start producing wine. She thinks that the company can produce wines for the next 7 years. In order to produce wines the company needs a new grape masher. The masher will cost $80,000 and an extra $10,000 will be needed for shipping and installation. This masher will be depreciated as a 5-year MACRS asset. Carla expects to sell the masher at the end of year 7 for $10,000. Carla estimates that the revenues will be $35,000 during year 1 and the revenues will grow by 10 percent per year for the next 7 years. Also she forecasts that annual year 1 operating expenses will be $10,000 and the expenses will grow at an annual rate of 5 percent per annum. For this new production Carla plans to use a factory which has been rented out for $7,500 per year for now. At the time the masher is purchased, Carla will invest $5,000 in net working capital. Additional investments in net working capital are required at the end of year 1 ($3,000) and year 2 ($2,000). The marginal tax rate for Carly’s Winery is 40% and the required rate of return for Carly’s Wineryis 12%.

a) Calculate the relevant cash flows for the evaluation of this project.

b) DecidewhetherCarlashouldinvestinthisproductionlineornot.

c) You think that this new production is riskier that Carly’s Winery’s ongoing operations. Briefly discuss if this new information changes your decision in part (b).

Answer 1

Answer a)

Relevant cash flows are calculated and are given below:

Answer (b):

Yes, Carla should invest in this production line.

NPV = $7,266.44

Working:

Answer (c):

You think that this new production is riskier that Carly’s Winery’s ongoing operations. When new production is riskier, required rate of return will increase as the risk increases.

Let us see how it will change the decision:

We calculate the IRR:

We observe IRR of the production line is 14.09%

So, if due to increase in risk, rate of required return increases above 14.09%, the new production line has to be rejected since at such discount rates NPV will be negative.

Hence if the new production line is riskier that Carly’s Winery’s ongoing operations, the decision as arrived in part b will change if rate of required return is higher than 14.09%.