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Saturday, February 5, 2011

Cash Flow Estimation and Risk Analysis - Robert Montoya, Inc.

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CASE 2
Cash Flow Estimation and Risk Analysis
Robert Montoya, Inc.
Robert Montoya, Inc., is a leading producer of wine in the United States. The firm was founded in 1960 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 1960s, 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 varietal red wine using the cabernet sauvignon grape. The new wine is designed 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, and then present her findings to the company’s executive committee.
Production facilities for the new wine would be set up in unused section of Robert Montoya’s main plant. New machinery with an estimated cost of $2,200,000 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  $150,000 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  $100,000  bottles of the new wine in each of the next  4 years, at a wholesale  price  of  $40 per  bottle, but $32 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 frim’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 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            =  Wd kd  (1 – T) + Ws ks
                                                =  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.


Questions

1.  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.

2.  Should the $300,000 that was spent to rehabilitate the plant be included in the analysis? Explain.

3.  Suppose another winemaker had expressed an interest in leasing the wine production site for $300,000 a year.  If this were true (in fact it was not), how would that information be incorporated into the analysis?

4.  What is Robert Montoya’s Year 0 net investment outlay on this project?  What is the expected no operating cash flow when the project is terminated at Year 4?  (Hint: Use Table 1 as a guide)

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

6. Now suppose the projects had involved replacement rather than expansion of existing facilities. Describe briefly how the analysis has to be changed to deal with a replacement project.

7.  A.  Assume that inflation is expected to average 5 percent per year over the next 4 years.  Does it appear that the project’s cash flow estimates are real or nominal?  That is are they stated in constant (Current year) dollars, or has inflation been built into the cash flow estimates?  (Hint: Nominal cash flows include the effects of inflation, but real cash flows do not.)

B.  Is the 10 percent cost of capital a nominal or a real rate?
                            
C.  Is the current NPV biased, and, if so, in what direction?

8.  Now assume that the sales price will increase be the 5 percent inflation rate beginning after Year 0. However, assume that cash operating costs will increase by only 2 percent annually from the initial cost estimate, because over half of the costs are fixed by long-term contracts.  For simplicity, assume that no other cash flows (net externality costs, salvage value or net working capital) are affected by inflation.  What are the project’s NPV, IRR, MIRR, and payback now that inflation has been taken into account?  (Hint : the Year 1, and succeeding cash flows, must be adjusted for inflation because the estimates are in Year 0 dollars.)

9. The second capital budgeting decision which Sharpe and you were asked to analyze involves choosing between two mutually exclusive projects. S and L whose cash flows are set forth below.

Expected Net Cash Flow
Year         Project S      Project L
                                                      0           ($400.000)    ($400,000)
                                                      1             240,000          134,000
                                                      2             240,000          134,000
                                                      3                  --                134,000
                                                      4                  --                134,000

Both of these projects are in Robert Montoya’s main line of business, table wine, and the investment which is chosen is expected indefinitely into the future .Also, each project is of average risk, hence each is assigned the 10 percent corporate cost of capital.
a.       What is project’s single-cycle NPV?  Now apply the replacement chain approach and then repeat the analysis using the equivalent annual annuity approach. Which project should be chosen, S or L? Why?
b.      Now assume that the cost to replicate Projects S in 2 years is estimated to be $420,000 because of inflationary pressures. Similar investment cost increases will occur for both projects in Year 4 and beyond, how would this affect the analysis? Which project should be chosen under this assumption?
10. The third project to be considered involves a fleet a trucks with an engineering life of 3 years (that is that truck will be totally worn out after 3 years). However, if the trucks were taking out of services, or “abandoned,” prior to the end of 3 years, they would have a positive salvage value. Here are the estimated net cash flows for each truck.

Year                            Initial Investment                                                   End-of-Year Net
                           And Operating Cash Flow                                       Abandonment Cash Flow
   0                                   ($60,000)                                                                          $60,000
   1                                      25,200                                                                              37,200
   2                                      24,000                                                                              24,000
   3                                      21,000                                                                                       0

The relevant cost of capital is again 10 percent.
a.       What would be NPV be if trucks were operated for the full 3 years?
b.      What if they were abandoned at the end of the Year 2? What if they were abandoned at the end of the year 1?
c.       What is the economic life of the truck project?

11. Refer back to the original wine project. In this and the remaining question, if you are using the Lotus 1-2-3 model, quantify your answer. Otherwise, just discuss the impact of the changes.
a.       What would happen to the projects profitability if inflation were neutral, that is, id both sales prices and cash costs increases by the 5 percent annual inflation rate?
b.      Now suppose that Robert Montoya is unable to pass along it inflationary input cost increases to its customers. For example, assume that cash costs increased by 5 percent annual inflation rate, but that the sales price can be increased at only at 2 percent annual rate.  What is the project’s profitability under these conditions?

12. Return to the initial inflation assumptions (5 percent on price and 2 percent n cash costs).
a.       Assume that the sales quantity estimate remains at 100,000 units per year. What Year 0 unit price would the company have to set to cause the project to just break even, that is, to force NPV=$50?
b.      Now assume that the sales price remains at $40. What annual unit sales volume would be needed for the project to break even?


Table 1
Project Cash Flow Estimates

Net Investment Outlay:                                      Depreciation Schedule:
Price
Freight
X
X
Basis =


MACRS
X

Depr

End-of-Year
Installation
X
Year
Factor

Expense
Book Value
Change in NWC
X
1
33%

$792,000
$1,608,000

X
2
X

X
X


3
X

X
X


4
7

168,000
0



100%

$2,400,000


Cash Flow Statements:

Year 0
Year 1
Year 2
Year 3
Year 4
Unit Price

$40
X
X
$40
Unit sales

100,000
X
X
100,000
Revenues

$4,000,000
X
X
4,000,000
Operating costs

3,200,000
X
X
3,200,000
Depreciation

792,000
X
X
168,000
Other project effects

20,000
X
X
20,000
   Before tax income

($12,000)
X
X
$612,000
Taxes

(4,800)
X
X
244,800
   Net income

($7,200)
X
X
$367,200
Plus depreciation

792,000
X
X
168,000
   Net op cash flow

$784,800
X
X
$535,200
Salvage value




$150,000
SV tax




X
Recovery of NWC




X
   Terminal CF




X
Project NCF               ($2,500,000)                      X
X
X
X


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