ROBERT MONTOYA, INC.
Introduction
The Good Wine Inc. a leading producer of wine in the United States. The firm was founded in 1950 by Robert Montoya, an Air Force veteran who had spent several years in France both before and after the World War II. This experience convinced him that California could produce wines that were as good as or better than the best France had to offer. Originally Robert Montoya sold his wine to wholesalers for distribution under their own brand names. Then in early 1950s, he joined with his brother Marshall and several other producers to form Robert Montoya, Inc., which then began an aggressive promotion campaign. Today, its wines are sold throughout the world. The table wine market has matured and Robert Montoya’s wine cooler sales have been steadily decreasing. Consequently, to boost winery sales, management is currently considering a potential new product: a premium variety red wine using the cabernet sauvignon grapes. The new wine is designed to appeal to middle-to-upper-income professionals. The new wine, Suave Mauve, would be positioned between the traditional table wines and super premium table wines. Ms. Sarah Sharpe, the financial vice-president, must analyze this project along with two other potential investments, and then present her findings to the company’s executive committee.
The Project
Production facilities for the new wine would be set up in an unused section of Robert Montoya’s main plant. New machinery cost is estimated at $2,200,000 plus $80,000 shipping cost to move it to Robert Montoya’s plant and additional $120,000 as installation charges. Furthermore, Robert Montoya’s inventories would have to be increased by $120.000 as of the time of the initial investment. The machinery has a remaining economic life of 5 years at the end of which it is expected to have a salvage value of $150,000. The section of the plant where production would occur had not been used for years and, consequently, has suffered some deterioration. Last year, as a part of a routine facilities improvement program, $300,000 was spent to rehabilitate that section of the main plant. The machine will be depreciated linearly.
Cash Flow Estimation
Robert Montoya’s management expects to sell 100,000 bottles of new wine in each of the next 5 years, at a wholesale price of $40 per bottle, but $32 per bottle would be needed to cover cash operating costs. The company expects that sales will grow at 2% above the inflation rate for the first three years and after only adjust by the inflation rate estimated at 3% in the next five years. In examining the sales figure, Ms. Sharpe noticed a note from Robert Montoya’s sale manager, which expresses the concern that the new wine would cut into firm’s sales of other wines. After discussing with the sale and production manager, Sharpe concluded that the project would reduce the firm’s existing wine sales by $60,000 per year, but at the same time, it would reduce production cost by $40,000 per year.
Cost of Capital
The firm’s WACC normally used for such investment opportunities was 12%. However this figure was based on a study of the company’s cost of capital conducted 10 years so the company decided to re-estimate the cost of capital based recent data provided by the financial department as per Table below.
|
Bank Loans |
Marker Risk Premium |
|
1-year 5.38% |
Historical Average 6% |
|
Government Bonds |
Corporate Bonds (10-year maturities) |
|
1-year 4.96% |
Aaa 5.37% |
|
5-year 4.57% |
Aa 5.53% |
|
10-year 4.6% |
A 5.78% |
|
30-year 4.73% |
Baa 6.25% |
|
Company Financial Data |
|
|
Balance sheet accounts ($millions) |
|
|
Bank loan payable (LIBOR =1%) |
500 |
|
Long term debt |
2,500 |
|
Common Equity |
500 |
|
Retained Earnings |
2,000 |
|
Per-share data |
|
|
Shares outstanding (millions) |
500 |
|
Book value per share |
$5.00 |
|
Recent market value per share |
$24.00 |
|
Other |
|
|
Bond Rating |
Aa |
|
Beta |
1.10 |
The applicable corporate tax rate is 35%. You are asked to value this investment. To this purpose:
Questions:
- Calculate the company’s cost of capital to be used for this project.
- Should the $300.000 spent to renovate the plant be included in the analysis of the incremental cash flow? And the negative externality of the new product on the existing wines? Explain.
- Compute the incremental cash flows and the NPV of the project? Should it be undertaken?
- Ms Sharpe acknowledges that the quantity of bottles of wines depends on the annual produce of grapes and that, if weather conditions are unfavorable, it could be too low thereby making difficult to achieve the target of a 100,000 bottles per year. Ms Sharpe therefore asks you to calculate the break even quantity of bottles.
- The second capital budgeting decision which Ms. Sharpe is asked to analyze involves the choice between two mutually exclusive projects, S and L, whose nominal cash flows streams are shown in the table below:
|
Year |
S |
L |
|
0 |
-$400,000 |
-$400,000 |
|
1 |
$240,000 |
$134,000 |
|
2 |
$240,000 |
$134,000 |
|
3 |
– |
$134,000 |
|
4 |
– |
$134,000 |
Both of these projects are in Robert Montoya’s main line of business, table wine, and the investment which is chosen is expected to be repeated indefinitely in the future. Sharpe considers that these two alternative projects are substantially less risky than the Sauve Mauve and hence that the appropriate discount rate is 8%.
- After calculating each project’s single-cycle NPV, discuss whether it would be correct to choose the project based on the previous results? Explain and make the appropriate calculations to motivate your answer.
- Compare the selected project with the project of introducing the new premium wine Sauve Mauve. Which of them is more profitable?
