Case I (due date: Mar 28) CocoMix Juices

Copyright 2008 by Dr. Gabriel G. Ramrez Bebidas-Sabrosas (B-S) Inc. is a producer and distributor of juice drinks. Currently, B-S has one line of tropical juices targeted to Hispanic communities in Chicago, LA, Miami, and New York. Three years ago, the firm decided to expand its operations and create a juice drink from Costa Rica made out of pipas. During these past three years, the engaged in research and development and conducted test marketing in Dallas. The results of the test market were very encouraging and B-S has decided to launch a product to its current market and to expand to Texas. The name of the new juice will be CocoMix. The applicable tax rate is 40% and the Comptroller has determined that the appropriate discounting rate for this type of project is 10%. The production process for CocoMix is very specialized but some production elements are similar to the ones used for existing drinks and thus both products will share some of the same equipment. The production process will be housed in an area not currently used by B-S. However, it is estimated that more distribution trucks will be necessary for a cost of $1.0 million and necessary new equipment will cost $0.8 million. These investments qualify for a Investment Tax Credit (ITC) of $10,000 which the firm can choose to take it all at once in year zero or distribute it equally over the life of the project. These are the only new investments in fixed assets required during the life of the project. The project is expected to last 10 years at which time it will be shot down. All investments in short- and long-term assets will be liquidated and the proceeds will be received (recorded) in year 11. Investments in working capital will be recovered at cost. It is estimated that the trucks could be sold for $200,000 and the equipment for $120,000. The depreciation method to use is the MACRS under which the trucks qualify as a 5-year property and the equipment as a 7-year property (Table 7.3 of your textbook presents the respective percentage to use for MACRS). There are also start-up costs (expenses) in the amount of $50,000 during the first year of operations. Variable cost of goods sold (CGS) will be 30% of sales in each year. The fixed part of CGS is presented below and reflects salaries (does not include depreciation). Working capital needs will vary with sales in the manner described below. Selling and Administration (S&A) expenses include advertising, promotions, sales and distributor salaries, and other direct personnel salaries. Sales for next year will be $4 million. The marketing department has been able to determine what portion of S&A expenses is variable and related to the level of sales. Because this is a new product, significant advertising and promotion will be required during the first two years of introduction and thus the budget will be fixed for these two years. As the product gets moving, most of the S&A expenses will be variable. The fixed part of S&A reflects the salaries of drivers and sales people hired as a result of CocoMix and a minimum level of advertising needed. These expenses are invariant to the level of sales. The pattern for S&A expenses is also provided below.

The production process for CocoMix is very specialized but some production elements are similar to the ones used for existing drinks and thus both products will share some of the same equipment. The production process will be housed in an area not currently used by B-S. The following information was obtained from several meetings among the head of the finance, marketing, production, and accounting departments. Great deal of the debate for this project has focused on the use of existing facilities by CocoMix. There isn't a consensus as to whether CocoMix project should be charged for the usage of these facilities. The head of the production department argues that these facilities are unused and thus should be free of charge: "Nobody is using the extra building and equipment. It costs the company nothing to give them to CocoMix. It is not fair to charge the project with something when there hasn't been a disbursement of cash on the

part of the company " The head of the finance department argues that even though the existing facilities are not in use by B-S, they are valuable assets that command a market price. He has estimated that the market price (replacement cost) of the building and equipment are $100,000 and $300,000 respectively. Because these are existing assets, the IRS has ruled that reevaluating them to replacement value and allocating them to CocoMix implies that the straight-line method be used for depreciation instead of MACRS. In this case, the building is estimated to have 30 years of life and the equipment 15 years. After 10 years (the termination date of the project), it is estimated that the salvage value of the building is $23,000 and that the equipment will have no value. Proceeds will be received in year 11. The head of the accounting department disagrees with both the production and finance department. He thinks that CocoMix should be charged with the amount of annual depreciation currently used for the existing facilities ($15,000). He also thinks that a pro-rated amount of several expenses such security officer's salaries, property taxes, cleaning crew salaries, CFO, Comptroller, President, managers, and supervisor salaries (selling and general expenses) must be charged to the project: "Every project in this firm has its share of the overhead expenses. CocoMix should not be any exception " Currently, all these expenses for B-S as a whole total $3,000,000. The pro-rated procedure uses the square footage. Since B-S occupies 10,000 square feet, the per-square-feet allocation of these expenses is $300. CocoMix will be occupying 1000 square feet of existing facilities, thus, the pro-rated amount of these expenses is $300,000 per year. The head of the production department argues that these overhead expenses are fixed. Her study of CocoMix indicates that it is only after year 5 that it will be necessary to add more personnel and to incur in larger overhead due to the growth of CocoMix. According to her calculations, an additional $ 150,000 per year of overhead expenses will be incurred after year 4 as a result of CocoMix growth. The production department also argues that the introduction of CocoMix will produce some losses in the sales of current juices: " It is indisputable that some customers of our current juices are going to switch to CocoMix. Thus, the sales estimates given in part (A) are overestimated since they include lost sales from other B-S products" She estimates that 4% of the estimated CocoMix sales are simply transfer sales and should not be considered as part of this project. The president of the company points out that if CocoMix is not introduced now, the competition will introduce something within 2 years and B-S will lose sales to that new product. Her estimate of these losses is 2% of CocoMix sales starting 2 years from now. Evaluate this capital budgeting proposal using the concepts and procedures covered in this course (Chapter 7 and section 8.1) including a NPV, a sensitivity and a break-even analysis. Present a typed report as described in your syllabus: This is a group case but there will be no presentations, we will analyze the case in class. A written report is required. This report has to be business-like with a maximum of 7 pages plus appendices. Use appendices to support the analysis presented in the main body of the report. The appendices have no limits on the number of pages.