Indian River Citrus Company is a leading producer of fresh,
frozen, and made-from-concentrate citrus drinks. The firm was
founded in 1929 by Matthew Stewart, a navy veteran who settled in
Miami after World War I and began selling real estate. Since real
estate sales were booming, Stewart’s fortunes soared. His
investment philosophy, which he proudly displayed behind his desk,
was “Buy land. They aren’t making any more of it.” He practiced
what he preached, but instead of investing in residential property,
which he knew was grossly overvalued, he invested most of his sales
commissions in citrus land located in Florida’s Indian River
County. Originally, Stewart sold his oranges, lemons, and
grapefruit to wholesalers for distribution to grocery stores.
However, in 1965, when frozen juice sales were causing the industry
to boom, he joined with several other growers to form Indian River
Citrus Company, which processed its own juices. Today, it Indian
River Citrus, Florida Sun, and Citrus Gold brands are sold
throughout the United States.
Indian River’s management is currently evaluating a new
product-lite orange juice. Studies done by the firm’s marketing
department indicate that many people who like the taste of orange
juice will not drink it because of its high-calorie count. The new
product would cost more, but it would offer consumers something
that no other competing orange juice product offers-35 percent
fewer calories. Lili Romero and Brent Gibbs, recent business school
graduates who are now working at the firm as financial analysts,
must analyze this project, along with two other potential
investments, and then present their findings to the company’s
executive committee.
Production facilities for the lite orange juice product would be
set up in an unused section of Indian River’s main plant.
Relatively inexpensive, used machinery with an estimated cost of
only $500,000 would be purchased, but shipping costs to move the
machinery to Indian River’s plant would total $20,000, and
installation charges would add another $50,000 to the total
equipment cost. Further, Indian River’s inventories (raw materials,
work-in-process, and finished goods) would have to be increased by
$10,000 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. 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
$100,000 after 4 years of use.
The section of the main plant where the lite orange juice
production would occur has been unused for several years, and
consequently it has suffered some deterioration. Last year, as part
of a routine facilities improvement program, Indian River spent
$100,000 to rehabilitate that section of the plant. Brent believes
that this outlay, which has already been paid and expensed for tax
purposes, should be charged to the lite orange juice project. His
contention is that if the rehabilitation had not taken place, the
firm would have to spend the $100,000 to make the site suitable for
the orange juice production line.
Indian River’s management expects to sell 425,000 16-ounce
cartons of the new orange juice product in each of the next 4
years, at a price of $2.00 per carton, of which $1.50 per carton
would be needed to cover fixed and variable cash operating costs.
Since most of the costs are variable, the fixed and variable cost
categories have been combined. Also, note that operating cost
changes are a function of the number of units sold rather than unit
price, so unit price changes have no effect on operating costs.
In examining the sales figures, Lili Romero noted a short memo
from Indian River’s sales manager which expressed concern that the
lite orange juice project would cut into the firm’s sales of
regular orange juice--this type of effect is
called cannibalization. Specifically, the sales
manager estimated that regular orange juice sales would fall by 5
percent if lite orange juice were introduced. Lili then talked to
both the sales and production managers and concluded that the new
project would probably lower the firm’s regular orange sales by
$40,000 per year, but, at the same time, it would also reduce
regular orange juice production costs by $20,000 per year, all on a
pre-tax basis. Indian River’s federal-plus-state rate is 40
percent, and its overall cost of capital is 10 percent.
Lili and Brent were asked to analyze this new project, along
with two other projects, and then to present their findings in the
Indian River’s executive committee. The information about the other
two projects is given below.
The second capital budgeting decision which Lili and Brent were
asked to analyze involves choosing between two mutually exclusive
projects, S and L, whose cash flows are set forth as follows:
- Indian River Citrus Company Indian River Citrus Company Is A Leading Producer Of Fresh Frozen And Made From Concentrat 1 (78.51 KiB) Viewed 14 times
business, orange juice, and the investment which is chosen is
expected to be repeated indefinitely into the future. Also, each
project is of average risk, hence each is assigned the 10 percent
corporate cost of capital. Which project should be chosen, S or L?
Why?
The third project to be considered involves a fleet of delivery
trucks with an engineering life of 3 years (that is, each truck
will be totally worn out after 3 years). However, if the trucks
were taken out of service, or “abandoned”, prior to the end of 3
years, they would have positive salvage values. Here are the
estimated net cash flows for each truck:
- Indian River Citrus Company Indian River Citrus Company Is A Leading Producer Of Fresh Frozen And Made From Concentrat 2 (98.38 KiB) Viewed 14 times
Brent have been asked to analyze the NPV over the trucks' full
three years of operation as well as earlier abandonment.
Questions:
1.What seems like the Problem in this company? Need
Identification
2. Data Analysis
a. incremental cash flow
b.opportunity cost
c. NPV
3.Generation of Alternative Solutions
4.Evaluation of Alternative Solutions
— - Expected Net Cash Flow Year Project S 0 ($100,000) 1 60,000 2 60,000 3 4 Project L ($100,000) 33,500 33,500 33,500 33,500
Year 0 1 2 3 Initial Investment and Operating Cash Flow ($40,000) 16,800 16,000 14,000 End-of-Year Net Abandonment Cash Flow $40,000 24,800 16,000 0