Question

Robert Montoya, Inc., is a leading producer of wine in the United States. The firm was founded in 1950 by Robert Montoya, an Air Force veteran who had spent several years in France both before and after World War II. This experience convinced him that California could produce wines that were as good as or better than the best France had to offer. Originally, Robert Montoya sold his wine to wholesalers for distribution under their own brand names. Then in the early 1950s, when wine sales were expanding rapidly, he joined with his brother Marshall and several other producers to form Robert Montoya, Inc., which then began an aggressive promotion campaign. Today, its wines are sold throughout the world.

            The table Wine market has matured and Robert Montoya's wine cooler sales have been steadily decreasing. Consequently, to increase winery sales, management is currently considering a potential new product: a premium red wine using the cabernet sauvignon grape. The new wine' is designed to appeal to middle-to-upper-income professionals. The new product, Suave Mauve, would be positioned between the traditional table wines and super premium table wines. In market research samplings at the company's Napa Valley headquarters, it was judged superior to various competing products. Sarah Sharpe, the financial vice president, must analyze this project, along with two other potential investments, and then present her findings to the company's executive committee.

            Production facilities for the new wine would be set up in an unused section of Robert Montoya's main plant. New machinery with an estimated cost of $1,800,000 would be purchased, but shipping costs to- move the machinery to Robert Montoya's plant would total $80,000, and installation charges would add another $120,000 to the total equipment cost. Furthermore, Robert Montoya's inventories (the new product requires aging for 5 years in oak barrels made in France) would have to be increased by $100,000. 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 company has obtained a special tax ruling that allows it to depreciate the equipment under the MACRS 3-year class life. Under current tax law, the depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively. The machinery is expected to have a salvage value of $200,000 after 4 years of use.

            The section of the plant in which production would occur had not been used for several years and, consequently, had suffered some deterioration. Last year, as part of a routine facilities improvement program, $300,000 was spent to rehabilitate that section of the main plant. Earnie Jones, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the wine project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $300,000 to make the plant suitable for the wine project.

            Robert Montoya's management expects to sell 125,000 bottles of the new wine in each of the next 4 years, at a wholesale price of $50 per bottle, but $30 per bottle would be needed to cover cash operating costs. In examining the sales figures, Sharpe noted a short memo from Robert Montoya's sales manager which expressed concern that the wine project would cut into the firm's sales of other wines-this type of effect is called cannibalization. Specifically, the sales manager estimated that existing wine sales would fall by 5 percent if the new wine were introduced. Sharpe then talked to both the sales and production managers and concluded that the new project would probably lower the firm's existing wine sales by $60,000 per year, but, at the same time, it would also reduce production costs by $40,000 per year, all on a pre-tax basis. Thus, the net externality effect would be -$60,000 + $40,000 = -$20,000. Robert Montoya's federal-plus-state tax rate is 25 percent, and its overall cost of capital is 10 percent, calculated as follows:

                                    WACC = W_d r _d (1-T) + W_sr_s

                                                = 0.5(10%) (0.6) + 0.5(14%)

                                                = 10%.

            Now assume that you are Sharpe's assistant and she has asked you to analyze this project, along with two other projects, and then to present your findings in a "tutorial" manner to Robert Montoya's executive committee. As financial vice president, Sharpe wants 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, Sharpe wants you to ask and then answer a series of questions as set forth next. Keep in mind that you will be questioned closely during your presentation, so you should understand every step of the analysis, including any assumptions and weaknesses that may be lurking in the background and that someone might spring on you in the meeting.

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 300,000 that was spent to rehabilitate the plant be included in the analysis?

C. Suppose another winemaker had expressed an interest in leasing the wine production site for $30,000 per year. If this were true (in fact it was not), how would that information be incorporated into the analysis?

D. What is Robert Montoya's Year 0 net investment outlay on this project? What is the expected nonoperating cash flow when the project is terminated in year 4?

Answer 1

.A Incremental Cash Flow:

Incremental Cash flow is the net addition to cash flow for taking up a project.

Considering the example of the New Wine Project,

Whole sale price per bottle=$50

Cash operating cost per bottle=$30

Net Cash inflow per bottle=(50-30)=$20

Annual Sales=125,000bottle

Annual Cash inflow=125000*20= $   2,500,000

Net external effect   per year of reducing sales of existing wine =-$20,000

Before tax annual incremental Cash flow=$2,500,000-$20,000= $ 2,480,000

Interest expense should not be included in the cash flow statement. Interest expense is considered in the cost of capital

B. 300,000 spent to rehabilitate the plant is a sunk cost. This amount has been already spent . Whether this New wine project is accepted or not, the amount of $300,000cannot be recovered. Hence , the amount of $ 300,000 should not be included in the analysis.

.C If the information regarding offer of lease of the site is true, the lease rental of $30,000 per year is the opportunity cost (income foregone).

The amount of $30,000per year should be included in the analysis as annual cash outflow(Cost)

.D. Year 0 Net Investment outlay:

Cost of machinery	$1,800,000
Shipping Cost	$80,000
Installation charges	$120,000
Increase in working capital	$100,000	(inventory increase)
Total Initial Outlay	$2,100,000

Non operating Terminal Cash Flow in year 4:

A	Before tax salvage Value	$200,000
B=A*(1-0.25)	After Tax Salvage Value	$150,000
C	Release of additional   working capital	$100,000
B+C	Total non operating Terminal Cash flow	$250,000

Expected nonoperating cash flow when the project is terminated in year 4: $250,000