Financial Manager: Orio Coffee House; It is February 1 2021. You work as Financial Manager at Orio Coffee House (OCH) known to be best coffee chains & wholesaler of bakery items in Brampton. Chief Executive Officer of Orio Coffee House Daniel Jackson has approached you to make a report on assessment of two investment proposals
Investment Proposals for Orio Coffee House
Daniel Jackson, CEO of OCH, has approached you to work on 2 investment proposals that the company is considering:
- Buying coffee roaster plant in Mexico.
- The Reconstruction of coffee shops to add the selling of yogurt.
Mr. Daniel reminds you to consider only relevant expense and income. “Relevant costs have to be occurring in the future,” He said. “And have to be unique from the status quo. For example, if we choose to buy the roaster plant, it is only the incremental revenue and costs related to the purchase that should be considered. We also need to take into account the opportunity cost associated with the alternatives.”
More details on both of investment proposal is written below. Mr. Daniel wants you to recommend after evaluation, if OCH should invest in one, both, or none of the investment proposals.
Mr. Daniel wants you to use 7% as the discount rate (i.e., the required return).
First Proposal of Investment in Roasted Coffee Plant
Mr. Daniel is considering investing in a coffee plant in Mexico where you can get cheap labor and there are proximal coffee farms that can decrease transportation costs.
The cost of acquisition of the plant is $7Million, which covers roasting equipment that originally cost $14Million when it was purchased 8 years ago. Some of the equipment is obsolete and need to be discarded, so an additional $2Million of equipment has to be purchased. The roaster plant currently has $2Million of available tax shield left, excluding any tax shield related to the equipment to be purchased.
The raw materials and direct labour used for manufacturing these products are 8% and 7% of sales, respectively. The processing costs for roasting are approximately 17% of total sales. All of these costs as a percentage of sales are expected to remain constant over the time horizon. The plant also needs 2 managers with fixed salaries of $50,000 each per year. Insurance cost for the plant and equipment is $40,000 per year.
Additional incremental production overhead costs (property taxes, maintenance, security, etc.) excluding depreciation are estimated as $75000 yearly. Wages are expected to rise with inflation (estimated to be 2%) over the time period, while other fixed costs are expected to remain steady.
Transportation related variable costs (gas, variable overhead, etc.) are estimated to be 12% of revenue, and include transportation of raw materials to the roaster and finished products to the port for delivery to OCH coffeehouses.
The roasted coffee plant is expected to produce 1.1M pounds of coffee for the first two years, with production dipping by 100,000 pounds per year after this due to lower productivity from the deteriorating equipment. Each pound of roasted coffee can be sold at $3.25 per pound (either to retail cafes, franchise cafes, or to wholesale partners), with the price expected to rise with inflation over time. Each pound of coffee can make 30 cups of coffee that can sell at an average retail price of $4.00 per cup. Mr. Daniel has stressed that the profitability of the plant base has to be looked at on a stand-alone basis, i.e., from the sales from the plant to buyers, not from retail cafés to customers.
Mr. Daniel wants to evaluate if project will be profitable after 5 years, as significant reinvestment will be needed after five years to keep the plant operational, so he wants you to evaluate the return on investment in that period using the investment criteria of payback period, NPV, and IRR. The following table will help in the calculations of the tax shield for the new equipment:
Tax Shield Formula:
Assume no salvage value when calculating the tax shield, and that the half-year rule applies for Class 43. The tax rate Mr. Daniel wants you to utilize is 25%. When calculating the tax shield, the present value should be in the same period as the initial investment (Year 0), which also means that deprecation (i.e., CCA) should not be taken from the cash flows in subsequent years since their tax shelter effects are already accounted for in the tax shield.
Reconstruction of Coffee Shops to add yogurt services
Mr. Daniel also ask you to evaluate the potential of developing several hundred stores into new store models with frozen yogurt services. 500 stores have been selected as candidates for development. It will cost $80,000 to convert each store, including modifications to refrigeration equipment, with these costs being capitalized with a 6% applicable CCA rate. The average modified coffee shop is expected to generate an additional $30,000 in after-tax cash flow every year. However, OCH is also estimated to lose about $15,000 in annual after-tax cash flow from these cafés due to yogurt sales cannibalizing existing coffee shops. In other words, some customers who normally would have purchased coffee would instead purchase yogurt.
The 500 stores have average annual rent of $36,000 each. Mr. Daniel wants you to evaluate the profitability of this investment after a seven-year period using the investment criteria of NPV.
- Identify which revenues and costs are relevant to your analysis and which costs are irrelevant. Summarize all the information that will be required for each investment proposal including describing the proposal and identifying the time horizon for each proposal evaluation.
2.Calculate the after-tax cash flows during the life of each of the projects.
3.Utilizing the after-tax cash flows from question 2 evaluate each investment proposal utilizing the following criteria (unless directed otherwise):
- Clearly indicate whether any of the above criteria support each of the project proposals and what the company should ultimately decide to do.