Cash Flow Estimation and Risk Analysis

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Cash Flow Estimation and Risk Analysis

Robert Montoya, Inc.

Robert Montoya, Inc., is a leading producer of wine in the United States. The firm was founded in 1960 by Robert Montoya, an Air Force veteran who had spent several years in France both before and after 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 the early 1960s, when wine sales were expanding rapidly , 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 increase winery sales, management is currently considering a potential new product: a premium varietal red wine using the cabernet sauvignon grape. The new wine is designed to middle-to-upper-income professionals. The new product, Suave Mauve, would be positioned between the traditional table wines and super premium table wines. In market research samplings at the company’s Napa Valley headquarters, it was judged superior to various competing products. Sarah Sharpe, the financial vice president, must analyze this project, and then present her findings to the company’s executive committee.

Production facilities for the new wine would be set up in unused section of Robert Montoya’s main plant. New machinery with an estimated cost of $2,200,000 would be purchased, but shipping costs to move the machinery to Robert Montoya’s plant would total $80,000, and installation charges would add another $120,000 to the total equipment cost. Furthermore, Robert Montoya’s inventories (the new product requires aging for 5 years in oak barrels made in France) would have to be increased by $100,000. This cash flow is assumed to occur 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 life. 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 $150,000 after 4 years of use.

The section of the plant in which production would occur had not been used for several years and, consequently, had suffered some deterioration. Last year, as part of a routine facilities improvement program, $300,000 was spent to rehabilitate that section of the main plant. Earnie Jones, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the wine project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $300,000 to make the plant suitable for the wine project.

Robert Montoya’s management expects to sell $100,000 bottles of the new wine in each of the next 4 years, at a wholesale price of $40 per bottle, but $32 per bottle would be needed to cover cash operating costs. In examining the sales figures, Sharpe noted a short memo from Robert Montoya’s sales manager which expressed concern that the wine project would cut into the frim’s sales of other wines – this type of effect is called cannibalization. Specifically, the sales manager estimated that existing wine sales would fall by 5 percent if the new wine were introduced. Sharpe then talked to both the sales and production managers and concluded that the new project would probably lower the firm’s existing wine sales by $60,000 year, but, at the same time, it would also reduce production costs by $40,000 per year, all on a pre-tax basis. Thus, the net externality...
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