Question

In three units of study, there will be application-focused cases due at the beginning of the class that will be provided by the instructor. These cases will be complex in nature and will require the application of course concepts to real-word business situations. Each case will have an associated rubric to highlight expectations. All submissions must be of professional quality and done in Microsoft Word, Microsoft Excel, or submitted as a PDF. Case: Investment Proposals for Ontario Coffee Home It is January 1, 2019. You are a Senior Analyst at Ontario Coffee Home (OCH), one of the leading coffee chains and wholesaler of coffee/bakery products in Ontario. The CEO of Ontario Coffee Home, Jerry Donovan, has reached out to you to draft a report to evaluate two investment proposals. Requirements 1. Identify which revenues and costs are relevant to your analysis, and which costs are irrelevant. Summarize all the information that will be required for each investment proposal, including describing the proposal and identifying the time horizon for each proposal evaluation. 2. Calculate the after-tax cash flows during the life of each of the projects. 3. Utilizing the after-tax cash flows from question 2, evaluate each investment proposal utilizing the following criteria (unless directed otherwise): a. Payback b. NPV 4. Clearly indicate whether any of the above criteria support each of the project proposals, and what the company should ultimately decide to do. Investment Proposals Jerry Donovan, CEO of OCH, wants you to evaluate two investment proposals that the company is considering: 1. The purchase of a coffee roaster plant in Cuba. 2. The re-development of coffee shops to accommodate the selling of frozen yogurt. Mr. Donovan reminds you that only relevant costs and revenues should be considered. “Relevant costs have to be occurring in the future,” explained Mr. Donovan. “And have to differ from the status quo. For example, if we choose to buy the roaster plant, it is only the incremental revenue and costs related to the purchase that should be considered. We also need to take into account the opportunity cost associated with the alternatives.” More details on each investment proposal are included below. Mr. Donovan wants you to recommend if OCH should invest in one, both, or none of the investment proposals. Required Return Mr. Donovan wants you to use 7% as the discount rate (i.e., the required return). Investment in Roasted Coffee Plant Mr. Donovan is considering purchasing a coffee plant in Cuba where labour is cheap and there are proximal coffee farms to help lower transportation costs. The acquisition price of the plant is $6M, which includes roasting equipment that originally cost $14M when it was purchased 8 years ago. Some of the equipment is on its last legs, so an additional $2M of equipment has to be purchased. The roaster plant currently has $2M of available tax shield left, excluding any tax shield related to the equipment to be purchased. The direct materials and direct labour used to manufacture these products are 8% and 7% of sales, respectively. The actual roasting processing costs are approximately 17% of sales. These costs as a percentage of sales are expected to remain consistent over the time horizon. The plant also requires two managers with fixed salaries of $50,000 each per year. Insurance for the plant and equipment is $40,000 per year. Other incremental manufacturing overhead costs (property taxes, maintenance, security, etc.) excluding depreciation are estimated to be $75,000 annually. Wages are expected to increase with inflation (estimated to be 2%) over the time period, while other fixed costs are expected to remain steady. Transportation variable costs (gas, variable overhead, etc.) are estimated to be 12% of revenue, and include transportation of raw materials to the roaster and finished products to the port for delivery to OCH coffeehouses. The roasted coffee plant is expected to produce 1.1M pounds of coffee for the first two years, with production dipping by 100,000 pounds per year after this due to lower productivity from the deteriorating equipment. Each pound of roasted coffee can be sold at $3.25 per pound (either to retail cafes, franchise cafes, or to wholesale partners), with the price expected to rise with inflation over time. Each pound of coffee can make 30 cups of coffee that can sell at an average retail price of $4.00 per cup. Mr. Donovan has stressed that the profitability of the plant base has to be looked at on a stand-alone basis, i.e., from the sales from the plant to buyers, not from retail cafés to customers. Mr. Donovan wants to see if the project will reach profitability after 5 years, as significant reinvestment will be needed after five years to keep the plant operational, so he wants you to evaluate the return on investment in that period using the investment criteria of payback period, NPV, and IRR. The following table will help in the calculations of the tax shield for the new equipment: Class CCA Rate Description 43 30% Machine and equipment to manufacture and process goods for sale Tax Shield Formula Assume no salvage value when calculating the tax shield, and that the half-year rule applies for Class 43. The tax rate Mr. Donovan wants you to utilize is 25%. When calculating the tax shield, the present value should be in the same period as the initial investment (Year 0), which also means that deprecation (i.e., CCA) should not be taken from the cash flows in subsequent years since their tax shelter effects are already accounted for in the tax shield. Redevelopment of Coffee Shops Mr. Donovan also wants you to evaluate the potential of developing several hundred stores into new store models with frozen yogurt services. Five hundred stores have been selected as candidates for development. It will cost $80,000 to convert each store, including modifications to refrigeration equipment, with these costs being capitalized with a 6% applicable CCA rate. The average modified coffee shop is expected to generate an additional $30,000 in after-tax cash flow every year. However, OCH is also estimated to lose about $15,000 in annual after-tax cash flow from these cafés due to yogurt sales cannibalizing existing coffee shops. In other words, some customers who normally would have purchased coffee would instead purchase yogurt. The five hundred stores have average annual rent of $36,000 each. Mr. Donovan wants you to evaluate the profitability of this investment after a seven-year period using the investment criteria of NPV.

Answer 1

To find the pay back period

= Total cash inflows / Total cash outflows

To find the Net Present Value (NPV)

= Total cash inflow - Total cash outflow

1. Investment in Roasted coffee plant

Relavent costs

• Aquisition cost of plant and machinery
• Aquisition cost of additional equipments
• cost of direct materials
• direct labour
• salary
• insurance
• other overheads
• transportation costs

Irrelevent costs

• Total cost of the tax
• cost of plant

irrelevent cost are a type of sunk costs and relevent cost are that comprise the inflows and outflows of the cash

2. Redevelopment of the coffee shop

Relevant costs

• Conversion of the stores
• after tax cash flows
• loss on after tax cash flows

Irrelevant costs

i think there is no any kind of irrelevant costs

NPV = Total cash inflows - Total Cash outflows

Now we have to calcuate after tax cash flows

After tax cash flows

1. Investment method

Year Cash flow   discount factor @ 7% Discounted cash flow

1	1100000	0.934	1027400
2	1100000	0.872	959200
3	1000000	0.814	814000
4	900000	0.761	684900
5	800000	0.711	568800
6	700000	0.664	534800
7	600000	0.621	372600
8	500000	0.581	290500

total amount after tax cash flow is 5252200

2. Redevelopment of coffee shop method

Year Cash flow Loss of cash flow Net cash flow Discount factor@ 6% Discountyed cash flow

1	30000	15000	15000	0.943	14145
2	30000	15000	15000	0.890	13350
3	30000	15000	15000	0.840	12600
4	30000	15000	15000	0.792	11880
5	30000	15000	15000	0.747	11205
6	30000	15000	15000	0.705	10575
7	30000	15000	15000	0.665	9975

amount of after tax cash flow is 83730

Computation of pay back period

Pay back period = total cash inflow / total cash outflows

1. Investment method

a. Cash inflow = 3575000 (total sales are the inflows)

b. Cash outflows =

cost of roasting equipment	1400000
cost of replacement equipment	200000
material cost @ 8% of sales	286000
labour cost @ 7% of sales	250250
roasting processing cost @ 17% of sales	607750
salary	50000
insurance	40000
manufacturing over heads	75000

transportation costs @ 12% of sales

429000

Total cash out flow 3380000

Pay back period = total cash inflow / total cash outflows

=3575000/3380000 = 1.057 years

2. Redevelopment of coffee shops

Total cash inflows = 30000

Total cash outflows = 80000

Pay back period = total cash inflow / total cash outflows

= 30000 / 80000 = 0.375 years

NPV

NPV= Total cash inflow - Total cash outflow

1. Investment method

= 3575000-3380000 = 1950000

2. Redevelopment method

= 30000 - 80000 = -50000

Analysis

In the pay back period method the Redevelopment of the coffee shop should be selected , because it has lower pay back period than the investment in the plant

In the NPV method the investment in the plant is better to select because it has a higher NPV than the redevelopment of the shop