Dragon Food Industries (DFI) is considering an expansion into the juice business and has paid a consultant for $12,000 for a technical feasibility of the project. The juice bottling project will have an investment horizon of 7 years.
DFI's juice bottling plant is expecting to be located in an unused building next to its existing headquarters. The unused building which is fully owned by DFI is also fully depreciated but has a commercial value of $750,000. At the inception of the project, the required equipment would cost $300,000, plus an additional
$50,000 for installation costs, while its inventories would rise by $30,000 and payables by $5,000. The equipment is depreciated over 7 years for tax purposes.
Sales volume is expected to total 120,000 bottles per year and expected selling price is
$2.50. The marketing plan is to boost up sales by 10% per annum in the second year and then 5% per annum for the subsequent years. The pricing strategy is to keep the selling price throughout the investment horizon as a result of intense rivalry among existing fruit juice manufacturers.
Manufacturing costs per unit are expected to remain at 60% of the selling price and will rise in line with inflation rate. The annual fixed operating costs are expected to be
$700,000 in the first year and will increase by $100,000 on annual basis to make for additional advertising expenditure to achieve the marketing strategy of growing the sales.
At the end of seven years, the residual value of plant is nil. The building can be disposed at $900,000.
The effective corporate taxation rate applied to operating income is 30%. The weighted average cost of capital is 11.5% and the inflation rate is estimated at 5%. CEO of DFI has a concern about the possibility that inflation may have been under estimated and that the costs may increase at a higher in the next 7 years.
1. Although CEO finds the project technically feasible, he is unsure whether proposed new project will create shareholder value. You have been asked to evaluate the project and make a recommendation as to whether it should be accepted or rejected.
2. Discuss how you would proceed with sensitivity analysis to address the CEO's concern.
3. Assuming that the CEO is now confident about all the estimates of variables affecting the cash flow except the sales volume. If product acceptance is low, the unit sales drop to 40,000 bottles per annum over the entire project horizon.
4. CEO is fearful that the new project may carry an extra risk compared to his existing business overall risk. He suggests that we increase the cost of capital by 4% as an add-on for the higher project risk. Discuss the implications on your decision in question 1 above.
5. Your answers to questions 1-4 should be structured in a professional report with a maximum of 7 pages plus any tables. Presentation of the report counts in the marking. Marks may be deducted for grammatical mistakes.