CASE STUDY IN CAPITAL BUDGETING “The Williams' farm" company is a leading producer of fresh, frozen, and made-from- concentrate orange and lemon drinks. After spending $90,000 in R&D and $25,000 in marketing research, the firm found that there is a significant demand for a new product - orange plus. The new product although more expensive than the existing competing brands offers 40% less calories and 90% less sugar. Production facilities for the orange plus product would be set up in an unused section of the company's main plant. This plant was built twenty years ago and the firm could earn a pre-tax rental income from it around $45,000 per year but had to pay for estate management costs $3,000 per year. The section of the main plant where new production would occur has been unused for several years, and consequently it has suffered some structural damage. Last year, as part of a routine facilities improvement program, the company spent $52,000 to rehabilitate that section of the plant and additional $27,000 might be needed if the plant will be used for the particular project. (This extra cost will not be depreciated). Relatively inexpensive, used machinery with an estimated cost of $800,000 would be purchased, but shipping costs to move the machinery to company's plant would total $120,000, and installation charges would add another $80,000 to the total equipment cost. Further "orange plus" inventories (raw materials, work-in-process, and finished goods) would have to be increased by $63,000 at the time of the initial investment and another $18,000 in year 3. 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 total equipment cost (including transportation and installation) under the MACRS method with depreciation allowances of 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 $126,000 after 4 years use. The management of the firm believes to sell 820,000 cartons of the new product in the first year expecting to increase by 15% in each of the next 3 years. The price will be $2.10 per carton, for the first year as part of a promotional campaign, and then the price will be $3.80 for the subsequent years. $1.50 per carton would be needed to cover fixed and variable cash operating costs. The firm used to pay $18,500 per year for insurance but with the new project the insurance cost for the company will rise to $27,600 per year. Moreover, all companies in the industry have to provide training to their employees on food safety at a cost of $28,000 per year. In examining the sales figures, you noted a short memo from the marketing manager expressing his concerns that the orange plus would cut the sales of the firm's sales of the classic orange juice offered by the firm. The new product will cut the sales of 420,000 units of the classic product per year. The unit price of the classic product is $1.7. The variable cost per carton of classic orange juice is $0,8 while the fixed production costs of the site that produces the classic product are $530,000 per year. method with depreciation allowances of 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 $126,000 after 4 years use. The management of the firm believes to sell 820,000 cartons of the new product in the first year expecting to increase by 15% in each of the next 3 years. The price will be $2.10 per carton, for the first year as part of a promotional campaign, and then the price will be $3.80 for the subsequent years. $1.50 per carton would be needed to cover fixed and variable cash operating costs. The firm used to pay $18,500 per year for insurance but with the new project the insurance cost for the company will rise to $27,600 per year. Moreover, all companies in the industry have to provide training to their employees on food safety at a cost of $28,000 per year. In examining the sales figures, you noted a short memo from the marketing manager expressing his concerns that the orange plus would cut the sales of the firm's sales of the classic orange juice offered by the firm. The new product will cut the sales of 420,000 units of the classic product per year. The unit price of the classic product is $1.7. The variable cost per carton of classic orange juice is $0,8 while the fixed production costs of the site that produces the classic product are $530,000 per year. The company has a pre-tax cost of debt 10% and cost of equity 14% and the capital structure of the firm consist of 50% debt and 50% common equity. The tax rate of the firm is 40%. QUESTIONS 1. Suppose another juice producer had expressed an interest in leasing the orange plus production site for $25,000 a year. How would you treat this information? 2. What is the project's NPV? 3. What qualitative factors you might consider before taking the final decision?