Question

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Newlands Brewery is evaluating a new product line for the production of two new cider brands...

Newlands Brewery is evaluating a new product line for the production of two new cider brands for the young affluent target market. The brewery is currently operating at its optimal capacity and it will have to invest in an expansion for new machinery and production space. The expected cash flows for the two cider brands are:
Project Cider A, Cashflows are as follows , Year 0=(25 000), Year 1=12 900, Year 2=10 900, Year 3 =8 300 and year 4=7 240.

Project Cider B, Cashflows are as follows , Year 0=(13 500), Year 1=7 230, Year 2=8 200, Year 3 =8 600 and year 4=5 400

Also the expected net income figures for the new product line are as follows

Project Cider A net incomes Year 1=6 728, Year 2=4 800, Year 3 =2 009 and Year 4= 7 420

Project Cider B net incomes Year 1=3 855, Year 2=4 725, Year 3=5 255 and Year 4 =1 864

Consider the following information:
• The average book value for Cider A project is R12,500,000
• The average book value for Cider B project is R6,800,000
• Management requires 15 percent for the project to go ahead based on accounting rate of return perspective
• The discount rate for a project of similar risk level is 10 percent
• Management requires a minimum payback of 1.75 years for the type of risk associated with this project

Required:
Taking into consideration that the two projects are independent and no scaling issues, what should Newlands Brewery do? Your answer should be supported by the analysis of the following calculations:
• Payback method
• Discounted payback method
• Accounting rate of return (using averages)
• Net present value
• Internal rate of return
• Profitability index
Now consider the presence of scaling issue, which project should Newland Brewery consider?

Solutions

Expert Solution

project cider A project cider B
Year 0 -25000 -13500
Year 1          12,900.00           7,230.00
Year 2 10900 8200
Year 3 8300 8600
Year 4 7240 5400
Total cash flows 14340 15930
(A ) Payback period ( in years )                    1.74                   0.85
For project cider A
PV @ 10 %
Year 0 -25000 -25000
Year 1 12900         11,727.27    -13,272.73
Year 2 10900           9,008.26      -4,264.46
Year 3 8300           6,235.91        1,971.45
Year 4 7240           4,945.02        6,916.47
Discounted Payback Period formula = Year before the discounted payback period occurs + (Cumulative cash flow in year before recovery / Discounted cash flow in year after recovery)
(B ) Discounted payback = 2 + .38                   2.38 :=2+ 4246/11180
For project cider B PV @ 10 %
Year 0 -13500 -13500
Year 1            7,230.00           6,572.73      -6,927.27
Year 2 8200           6,776.86         -150.41
Year 3 8600           6,461.31        6,310.89
Year 4 5400           3,688.27        9,999.17
Discounted Payback Period formula = Year before the discounted payback period occurs + (Cumulative cash flow in year before recovery / Discounted cash flow in year after recovery)
Discounted payback = 2+.01                   2.01 :=2+ 150/10150
(C ) Accounting rate of return
Project cider A Project cider B
Year 1 6278 3855
Year 2 4800 4725
Year 3 2009 5255
Year 4 7420 1864
TOTAL net incomes 20507 15699
Avg net income 5126.75 3924.75
Investment 25000 13500
ARR                  20.51                29.07
(D) NET PRESENT VALUE
NPV Project cider A
Cash flows PV @ 10 % 10%
Year 0 -25000
Year 1 12900         11,727.27
Year 2 10900           9,008.26
Year 3 8300           6,235.91
Year 4 7240           4,945.02
PV OF all cash flows        31,916.47
NPV ( pv - initial investment           6,916.47
NPV Project cider b
Cash flows PV @ 10 %
Year 0 -13500
Year 1            7,230.00           6,572.73
Year 2 8200           6,776.86
Year 3 8600           6,461.31
Year 4 5400           3,688.27
PV OF all cash flows        23,499.17
NPV ( pv - initial investment           9,999.17
(D) Internal rate of return
NPV Project cider A
Cash flows PV @ 23.77 %
Year 0 -25000
Year 1 12900         10,422.56
Year 2 10900           7,115.34
Year 3 8300           4,377.56
Year 4 7240           3,085.16
PV OF all cash flows        25,000.61
rate at which the NPV is zero IRR 23.77%
NPV Project cider b
Cash flows PV @ 41.95 %
Year 0 -13500
Year 1            7,230.00           5,093.34
Year 2 8200           4,069.52
Year 3 8600           3,006.71
Year 4 5400           1,330.00
PV OF all cash flows        13,499.58
rate at which the NPV is zero IRR 41.95%

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