I

14
Cash Flow E
Robert Monto
Robert Montoya, Inc., is a leading pro
The f i r m was founded in 1950 by Rob
who h a d spent several years i n Fra
War I I . T h i s experience convinced h
wines t h a t were as good as or better
Originally, R o b e r t M o n t o y a s o l d
distribution under t h e i r own brand
when w i n e sales were expanding ra
Marshall a n d several other produce
which then began an aggressive promo
sold throughout the world.
The table wine market has ma
cooler sales have been steadily decr
winery sales, management i s curre
product: a premium varietal red wine u
The n e w w i n e i s designed t o ap
professionals. T h e n e w product, Sua
between the traditional table wines a
market research samplings at the com
was judged superior to various comp
financial vice president, must analyze
potential investments, and then pres
executive committee.
Production facilities for the new
section o f Robert Montoya's m a i n
estimated cost o f $2,200,000 would be
Copyright 1 9 9 4 The Dryden Press. All r
 Part IV C a p i t a l Budgeting Case 14 Cash Flo
move the machinery to Robert Montoya's plant would total $80,000, and Nov assume that you are Sharpe'
installation charges would add another $120,000 to the total equipment to analyze this project, along with two o
cost. F u r t h e r m o r e , Robert Montoya's inventories ( t h e n e w p r o d u c t your findings i n a "tutorial" manne
requires aging for 5 years in oak barrels made in France) would have to be committee. A s financial vice president,
increased b y $100,000. This cash flow is assumed to occur at the time of the other executives, especially the mar
the initial investment. The machinery has a remaining economic life of 4 theory o f capital budgeting so that the
years, and the company has obtained a special tax ruling that allows it, to understanding o f capital budgeting de
depreciate t h e equipment under t h e MACRS 3 -year class life. U n d e r you to ask and then answer a series of q
current tax law, the depreciation allowances are 0.33, 0.45, 0.15, and 0.07 mind that you will be questioned closely
n Years 1 through 4, respectively. The machinery is expected to have a should understand every step of the an
salvage value of $150,000 after 4 years of use. and weaknesses that may be lurking in
The section o f the plant in which production would occur had n o t might spring on you in the meeting.
been u s e d f o r several years a n d , consequently, h a d suffered s o m e Specifics o n t h e other two proje
deterioration. L a s t year, a s p a r t o f a routine facilities improvement provided in Questions 9 and 10.
program, $300,000 was spent t o rehabilitate t h a t section o f the m a i n
plant. Earnie Jones, the chief accountant, believes that this outlay, which
Questio
has already been paid and expensed for tax purposes, should be charged
to the w i n e project. His contention is t h a t i f the rehabilitation had n o t
1. D e f i n e t h e term "incremental cash
taken place, the firm would have had to spend the $300,000 to make the
financed i n p a r t by debt, should
plant suitable for the wine project. interest expenses? Explain.
Robert Montoya's management expects to sell 100,000 bottles of the
new w i n e i n each o f the next 4 years, a t a wholesale price o f $40 p e r 2. S h o u l d t h e $300,000 that was sp
bottle, but $32 per bottle would be needed to cover cash operating costs. In included in the analysis? Explain.
examining t h e sales figures, Sharpe noted a short memo from Robert
3. S u p p o s e another winemaker had ex
Montoya's sales manager which expressed concern that the wine project
wine production site for $30,000 a
would cut into the firm's sales of other wines—this type of effect is called
was n o t ) , h o w would t h a t inform
annibalization. Specifically, the sales manager estimated t h a t existing analysis?
wine sales would fall b y 5 percent i f the new wine were introduced.
Sharpe t h e n talked t o both t h e sales a n d production managers a n d 4. W h a t i s Robert Montoya's Year 0
concluded t h a t the new project would probably lower the firm's existing project? W h a t is the expected no
wine sales by $60,000 per year, but, at the same time, it would also reduce project is terminated at Year 4? (Hi
production costs by $40,000 per year, all on a pre-tax basis. Thus, the net
5. E s t i m a t e the project's operating cas
externality effect would b e —$60,000 + $40,000 = —$20,000. R o b e r t
as a guide.) W h a t are the project's
Montoya's federal-plus-state tax rate is 40 percent, and its overall cost of
and payback? Should the project b
capital is 10 percent, calculated as follows:
MIRR is found in three steps: (1) co
to the terminal year at the cost o f
cash inflows to obtain the terminal
WACC = Wdkd (1 — T) + Wsks the discount rate which forces t h e
= 0.5(10%) (0.6) + 0.5(14%) value to equal the present value of
discount rate is defined as the MIRR
= 10%.
 Part IV Capital Budgeting Case 14 Cash Flow
6. N o w suppose t h e project h a d involved replacement r a t h e r t h a n a. W h a t i s each project's single
expansion o f existing facilities. Describe briefly h o w t h e analysis replacement chain approach and
would have to be changed to deal with a replacement project. the equivalent annual annuity a
chosen, S or L? Why?
7. a . A s s u m e that inflation is expected to average 5 percent per year
over the next 4 years. Does it appear that the project's cash flow b. N o w assume that the cost to re
estimates a r e real o r nominal? - T h a t is, are t h e y stated i n estimated t o h e $420,000 beca
constant (current year) dollars, o r has inflation been b u i l t into Similar investment cost increase
the cash flow estimates? ( H i n t : Nominal cash flows include the Year 4 and beyond. How would
effects of inflation, but real cash flows do not.) project should be chosen under th
b. I s the 10 percent cost of capital a nominal or a real rate? 10. T h e third project to be considered in
engineering life of 3 years (that is, th
c. I s the current NPV biased, and, i f so, in what direction?
after 3 years). However, i f the truck
8. N o w assume t h a t t h e sales price w i l l increase b y t h e 5 percent "abandoned," prior to the end of 3 ye
inflation rate beginning after Ye a r 0. However, assume t h a t cash salvage value. Here are the estimate
operating costs w i l l increase by only 2 percent annually from the
initial cost estimate, because over h a l f of the costs a r e fixed b y Initial Investment
long-term contracts. For simplicity, assume that no other cash flows Ye a r a n d O p e r a t i n g Cash F l o
(net externality costs, salvage value, o r net working capital) are 0 ($60,000)
affected by inflation. What are the project's NPV, IRR, MIRR, and 1 25,200
payback now that inflation has been taken into account? ( H i n t : T h e 2 24,000
Year 1, and succeeding cash flows, m u s t be adjusted f o r inflation 3 21,000
because the estimates are in Year 0 dollars.)
The relevant cost of capital is again 1
9. T h e second capital budgeting decision which Sharpe and you were
asked to analyze involves choosing between two mutually exclusive a. W h a t would the N P V be i f the
projects, S and L, whose cash flows are set forth below: full 3 years?
b. W h a t i f they were abandoned at t
Expected Net Cash Flow were abandoned at the end of Yea
Year Project S Project L c. W h a t is the economic life of the tr
0 ($400,000) ($400,000 )
240,000 134,000 11. R e f e r back to the original wine proje
240,000 134,000 questions, i f you are using the Lotu
3 134,000 answer. Otherwise, just discuss the im
4 134,000
a. W h a t would happen to the projec
neutral, that is, i f both sales price
Both of these projects are in Robert Montoya's main line of business, 5 percent annual inflation rate?
table wine, and the investment which is chosen i s expected to be
repeated indefinitely into the future. Also, each project is of average h. Now suppose t h a t Robert Monto
risk, hence each is assigned the 10 percent corporate cost of capital. inflationary input cost increases
assume that cash costs increase by
rate, but that the sales price can b
 Part IV Capital Budgeting
annual r a t e . W h a t i s t h e project's profitability u n d e r these
conditions?
12. R e t u r n to the initial inflation assumptions (5 percent on price and
2 percent on cash costs).
15
a. A s s u m e t h a t t h e sales quantity estimate remains a t 100,000
units per year. What Year 0 unit price would the company have Risk Analy
to set to cause the project to just break even, that is, to force NPV Capital Bud
= $0?
b. N o w assume that the sales price remains at $40. What annual
unit sales volume would be needed for the project to break even?
Table 1 Robert Monto
Project Cash Flow Estimates
:Vet Investment Outlay: Depreciation Schedule: In Case 14, Sarah Sharpe, the finan
Price X Basis = X cabernet sauvignon red wine project
MAC RS Depr. End- o f -Year
Freight X
Book Va l u e
project required a n i n i t i a l investmen
Installation X Year Factor Expense
S 792,000 $1,608,000 (including shipping and installation ch
Change in NWC . & 1 33%
X 2 X X X to net working capital. T h e machiner
3 X X X depreciated on the basis of a 3-year MA
7 168900 .0
4 MACRS depreciation allowances are 0.3
Itric S"-, 400 MO
through 4, respectively, and the machin
value of $150,000. I f the project is und
Cash F l o w Statements: 100,000 bottles o f wine at a current d
Year 0 Year 1 Year 2 Year 3 Year 4
$40 per bottle. However, the sales pri
$ 4 0 X X $ 4 0 which is expected to average 5 percent
Unit price
100.000 X X 100.000
Unit sales
$4,000,000
sales price at the end of the first year is
Revenues S 4,000,000 X X
X X 3,200,000 end of the second year is $44.10 and so o
Operating costs 3,200,000
792,000 X X 168.000 The red wine project is expected
Depreciation
20.000 X __X 20.000 Robert Montoya currently earns on it
Other project effects
X X $ 612,000
Before tax income ($ 1 2 , 0 0 0 ) because the product lines are somew
(4.800) X __X 244.800
Taxes
X $ 367,200 company expects cash operating costs
Net income ($ 7 , 2 0 0 ) X
792.000 X __N 168.000 dollars, and i t expects these costs to i
Plus depreciation
Net op cash flow $ 754.800 __X X $ 535.200 Therefore, total variable costs during th
$ 150,000 are expected t o b e ($32.00)(1.02)(10
Salvage value
X
SV tax
X
Montoya's tax rate is 40 percent, and
Recovery of NWC Cash flow data and other information,
Termination CF
($2,5D0,(100 ) X ..I
Tc xX Lotus 1.2.3 model, are given in Table 1.
Project NCF
Copyright() 1994 The Dryden Press. All rig