Choconow Capital Budgeting

Capital Budgeting (5 points) – Choconow case

You work as Project Manager in “Hot and Quick beverages”, a company that manufactures and sells premium expresso machines for the European market.

You are very excited because your company wants to undertake a very ambitious project about a new machine based on the Nespresso model but for hot chocolates called “Choconow”.  The main difference with Nespresso is that the Choconow machine is more expensive than an Expresso machine but that the capsules are cheaper and therefore in our analysis will be ignored both in sales and costs (we will only focus on the sales of the machine itself).

You have been asked to measure the consequences of such an investment for your company, especially from a financial point of view.

The life cycle of this product will be limited to 3 years (Years 1 to 3). All cash flows are considered at the end of year.

You will consider a marginal income tax rate of 35% and that the company is globally profitable. The opportunity cost of capital of the company is 15%.

As it is a new product, it is quite hard to have precise financial estimates, so you decided to buy a feasibility study for €100,000 done by Audenture Company.

The results given by the feasibility study are gathered below.

Investment

• An investment in a new production line (including the warehouse itself) will be undertaken at the end of Year 0 for a total amount of €20 millions.
• The production line will be depreciated on a straight-line basis over a five-year period.
• The production line will be sold in year 4 for a price of €9 million (You will consider only 3 years of depreciation for the calculation of the residual value as the production line is not really used in year 4 so it will not lose value).

Marketing

• The company should be able to sell 120,000 units of Choconow in Year 1, 300,000 units in Year 2 and 200,000 units in Year 3. The selling price per unit will remain constant at €300 per unit.
• The sales of Choconow should decrease the sales of the existing espresso model by 80,000 units each year (sale price of the expresso model is €350 per unit).

Production Costs

• The cost of sales has been evaluated to €120 per unit.
• And previous analysis showed that cost of sales of the expresso model is equal to €150 per unit.

Other Operating Expenses

• The new product will require additional overheads of €7 million and marketing costs amounting €3 million per year.
• The land on which the production line of Choconow will be built was previously rent to an administration for €20,000 per month.

Working Capital linked to the project

• Inventories are equal to 20% of the Revenues net of Cannibalization.
• The account receivables are equal to 15% of the Revenues net of Cannibalization.
• The accounts payable are equal to 10% of the Revenues net of Cannibalization.
• The company estimates that it will recover the Net Working Capital in Year 4.

1. The After tax Selling price of the machine in Year 4 is 8,650 k€. Please show below the details of the calculation of this amount. (0.5 point)

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1. Please calculate the increase in Net Working Capital ($000s) (0.5 point)

1. Please determine the free cash flows of the project using the template below (3 points)

Incremental Earnings Forecast ($000s)

1. Please calculate the net present value (NPV) of the project. (0.5 point)

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1. Should the managers undertake this investment? Justify your answer. (0.5 points)

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