QUESTION 1 [35 MARKS] Background Local Brews (Pty) Ltd is a small coffee roastery established 5 years ago in Westville,

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Question 1 35 Marks Background Local Brews Pty Ltd Is A Small Coffee Roastery Established 5 Years Ago In Westville 1 (113.7 KiB) Viewed 18 times

QUESTION 1 [35 MARKS] Background Local Brews (Pty) Ltd is a small coffee roastery established 5 years ago in Westville, a city in Westland, which distributes roasted coffee beans across the country. Westland's currency is the Westland Dollar ("W$"). Over recent years the popularity of coffee in Westland, has grown steadily, with Local Brews experiencing an increasing demand for its roasted coffee beans throughout the country. Establishment of a second coffee roastery Assume today is 1 July 2022. You have been approached by the management of Local Brews to be part of a small project team involved in considering the feasibility of, and assisting the private company in, expanding its operations. During the preceding months (at a total cost of W$150,000), members of the team visited and met with several people at towns and sites across the country to identify and consider possible investment opportunities. The company is now considering expanding its manufacturing capacity by establishing a second roasting facility in the coastal town of Coastville, some distance from Westville. During a visit to Coastville, the project team identified a current coffee roastery facility, which is currently for sale. The coffee roastery was established by a local businessman who had a passion for coffee, but lost interest in the venture. The roastery is fully equipped, but due to some neglect - currently not functional to roast and distribute the capacity planned by Local Brews for its second site. The project team met the current owner, who indicated that he would be willing to sell the roastery as is for W$1.25 million. The project team is currently drafting a proposal to the management of Local Brews, which includes a project time line to commission the second roastery. If approved, preparation to commission the roastery will start immediately (1 July 2022), with commercial activities (roastery and distribution) to commence from 1 July 2023 onwards. The proposal will include a financial feasibility, which you have been requested to calculate. Coastville roastery (normal scenario) The following estimates and information are available: Projected production and sales for the first four years after commercial activities commence on 1 July 2023: Description July 2023 July 2024 July 2025 July 2026 Notes to June to June to June 2024 to June 2025 2026 2027 Coffee beans roasted and sold (kg) 5 400 ? ? ? 1 & 2 W$275 ? ? ? 3 Average selling price achieved per kg (W$) Price of raw coffee beans (including freight charges) (US$ per kg) US$8 ? ? 4 & 5 Other direct costs (W$ per kg) W$15 ? 6 & 7 Variable indirect costs (W$ per kg) W$25 ? 7 ? ? ? ? ?
Description July 2024 July 2025 July 2026 Notes July 2023 to June 2024 to June to June to June 2025 2026 2027 Coffee beans roasted and sold (kg) 5 400 ? ? ? 1 & 2 Average selling price achieved per kg (W$) W$275 ? ? ? 3 US$8 ? ? ? 4 & 5 Price of raw coffee beans (including freight charges) (US$ per kg) Other direct costs (W$ per kg) W$15 ? ? ? 6 & 7 Variable indirect costs (W$ per kg) W$25 ? ? ? 7 Total fixed indirect costs (W$) W$450,000 ? ? ? 7 1. It is assumed that all coffee beans roasted will be sold in the same year. 2. The quantity of coffee beans roasted and sold will increase with 10% per year (from July 2024 onwards) The assignment continues on the next page. 1 3. As a result of the increasing popularity of coffee in Westland, Local Brews anticipates increasing the selling price of its roasted coffee by 7% each year (from July 2024 onwards). 4. Due to expected increased global demand for raw coffee beans and supply chain interruptions, it is estimated that the average price of raw coffee beans, denominated in United Stated Dollar (US$) will increase with 4% per year during the medium to long term (from July 2024 onwards). 5. Economists estimate that the Westland Dollar will trade at an average of W$10 to 1US$ in the first year of commercial activities (July 2023 to June 2024), after which (from July 2024 onwards) the Westland Dollar will weaken against the US$ with an average of 5% per year over the medium to long term. 6. Not included in the direct costs tabled, is depreciation calculated on furniture, equipment and machinery used in the roastery operations, of W$250,000 per year. 7. For the duration of the project, it is estimated that other direct costs and indirect costs (thus all costs except the raw coffee beans) - will increase with an average inflation rate of 3% per year (from July 2024 onwards). (Refer to note 4 regarding the price of raw coffee beans).
The following additional information is also provided: Upon approval of the proposal by the management of Local Brews, the full asking price for the roastery of W$1.25 million will be paid immediately (1 July 2022) to the current owner. Further improvements will be made to the roastery, to the value of W$250,000, between July 2022 and June 2023. The market value of the Coastville roastery is estimated at W$2 million on 30 June 2027. The management of Local Brews requires that all investment made yield a minimum return of 14%. Income tax of 25% applies to the operations of the company. You may assume that Westland applies the same tax principles as South Africa. The tax implications of "Wear and Tear" and "scrapping" allowances, Value Added Tax and Capital Gains Tax can be ignored. Furthermore, in addition to the above normal scenario, the project team is considering the following variables to the current estimate scenarios (all other estimates remain the same). Description Scenario Scenario B Scenario C Revenue (coffee beans roasted and The quantity of coffee beans sold) roasted and sold will increase with 5% per year (from July 2024 onwards) The quantity of coffee beans roasted and sold will increase with 15% per year (from July 2024 onwards) W$:US$ exchange rate W$ weaken against the US$ with an average of 7% per year over the medium to long term (from July 2024 onwards). W$ strengthen against the US$ with an average of 4% per year over the medium to long term (from July 2024 onwards). Inflation on indirect costs (estimate inflation on direct costs remains unchanged) 2% per year (from July 2024 onwards). 8% per year (from July 2024 onwards). Financing The project team has advised that the project should be financed with debt as increased gearing will reduce the weighted average cost of capital of the company. The Chief Financial Officer (CFO) responded that he was not sure what gearing meant, but that he had heard that debt would increase the risk of the company. The assignment continues on the next page. 2
REQUIRED Marks Sub- Total total 20 25 1.1 In respect of the normal scenario, evaluate the financial feasibility of the Coastville roastery in terms of the net present values (NPV) and internal rate of return (IRR) and advise the company, from a financial perspective, whether the company should proceed with the project. Support your answer with appropriate calculations and motivate costs incurred, but not included in your solution. Guidance: the structure of the cashflow timing are as follows: July 2024 July 2025 July 2026 1 July 2022 July 2022 July 2023 to June 2023 to June to June to June to June 2024 2025 2026 2027 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 (W$) (W$) (W$) (W$) (W$) (W$) 5 1.2 In respect of scenario's B and C, calculate, compare and present the NPV, IRR and variables of all three respective scenarios making use of the MS Excel Scenario Manager function. 1.3 Identify the key risks that Local Brews will be exposed to with the Coastville roastery 4 project 1.4 Explain the following to the CFO of Local Brews: 6 i) the principle of gearing; ii) why debt is cheaper than equity; and iii) what the effect will be on risk if more debt than equity is used as a source of finance. TOTAL TOTAL: 35 MARKS 35