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 40 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.

5. Estimate the project’s operating cash flows. (Hint: Again use Table 1 as a guide.) What are the project’s NPV, IRR, modified IRR (MIRR), and payback? Should the project be under-taken?

Fill in Xs. Payback period of S = about 2 years, L = about 3 years. Omit MIRR.

6. 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.

Depreciable basis = price + freight + installation. In year 1, 2,000,000 X 33% (or 0.33) MACRS factor = 660,000 (depreciation expense). 2,000,000 – 660,000 = 1,340,000 end-of-year book value.

            MACRS          Depr.               End-of-year

Year    Factor              Expense           Book Value

1         33%                     660,000                  1,340,000

2          X                     X                                 X

3          X                     X                                 X

4          7                     140,000                                0                   

            100%               1,800,000

                       

Cash Flow Statements:

                                    Year 0             Year 1             Year 2             Year 3             Year 4

Unit price                                            $           50       X                     X         $          50

Unit sales                                            100,000        X                     X              100,000

Revenues                                             5,000,000        X                     X         5,000,000

Operating costs                                   3,000,000        X                     X         3,000,000

Depreciation                                           660,000        X                     X              140,000

Other project effects                              20,000        X                     X                20,000

Before tax income                               1,320,000        X                     X         1,840,000

Taxes                                                     528,000        X                     X              736,000

Net income                                             792,000        X                     X         1,104,000

Plus depreciation                                    660,000        X                     X              140,000

Net op cash flow                                 1,452,000        X                     X         1,244,000

Salvage value                                                                                                       200,000

SV tax                                                                                                                            X

Recovery of NWC                                                                                                       X

Termination CF                                                                                                              X

Project NCF                ($-2,100,000)              X         X                     X                        X

                                    =========                =          =                      =                         =

Answer 1

Year	MACRS/F	Depr.	EOY BV
0			2000000
1	33%	660000	1340000
2	45%	900000	440000
3	15%	300000	140000
4	7%	140000	0
	100%	2000000

Cash flow Statement
	Year 0	1	2	3	4
Unit price		50	50	50	50
Unit sales		125000	125000	125000	125000
Revenues		6250000	6250000	6250000	6250000
Less:
Cash opg. Costs at 30/unit		3750000	3750000	3750000	3750000
Depreciation as above		660000	900000	300000	140000
Other project effects		20000	20000	20000	20000
Before tax Income		1820000	1580000	2180000	2340000
Less:Taxes at 40%		728000	632000	872000	936000
Net Income		1092000	948000	1308000	1404000
Add Back: Depn		660000	900000	300000	140000
Annual Opg. Cash flow--------1		1752000	1848000	1608000	1544000
a.After-tax salvage(200000*(1-40%)					120000
b.NWC introduced & recovered	-100000				100000
c.Initial investment	-2000000
Net annual cash flows(1+a+b+c)	-2100000	1752000	1848000	1608000	1764000
PV F at 10%	1	0.90909	0.82645	0.75131	0.68301
PV at 10%	-2100000	1592727	1527273	1208114	1204836
NPV	3432950
IRR	75%
MIRR	40%
Ordinary Pay back period
Net annual cash flows	-2100000	1752000	1848000	1608000	1764000
Cumulative cash flows	-2100000	-348000	1500000	3108000	4872000
1+(348000/1848000)=
1.19
Years
Discounted Pay back period
PV at 10%	-2100000	1592727	1527273	1208114	1204836
Cumulative cash flows	-2100000	-507273	1020000	2228114	3432950
1+(507273/1527273)=
1.33
Years
The project can be undertaken as it generates POSITIVE NPV

2.. If it is a replacement project, rather than an expansion one,we need to consider the incremental costs, incremental depreciation & tax shields available as well as incremental revenues , in the project analysis

It will be a sort of comparison with the existing one, from all angles, cost, revenues and tax savings.

The replacement should earn positive NPV so as to justify the change.