CAPITAL BUDGETING CASE
Alamo Cereal Company currently produces cereal targeted to consumers over 40 years of age. Sales have steadily declined over the last 10 years resulting in a decision to shut down the manufacturing plant. The plant was built 40 years ago at a cost of $28,000,000 and is now fully depreciated. A rival cereal company has offered to purchase the existing facility for $15,000,000 in as is condition.
The Vice President in charge of the plant has developed an alternative to closing the plant. The Vice President has proposed using the existing plant to manufacture wheat flakes targeted to consumers under 10 years of age. The VP estimates sales of wheat flakes to be 400,000 cases in the first year, 600,000 cases in the second year, and to escalate at 4% annually thereafter. The sales price of wheat flakes will be $110 per case in year one, $130 per case in year two, and will increase 4% annually thereafter.
1,000 cases of cereal can be produced from one ton of grain. In year one, the price of wheat (per ton) is estimated at $31,000. The price of wheat is expected to increase 4% annually. For each ton of grain, 1/2 ton of sugar will be added. In year one the price of sugar is estimated at $92,000 per ton and is expected to increase at 3% annually. For each ton of grain, 1/10 ton of vitamin enriched additives will be required. The cost per ton of vitamin enriched additives will be $125,000 in year one and will escalate 2% annually.
The plant will employ 75 hourly workers, in year one, 80 hourly workers in year two, 110 hourly workers in year three, 115 hourly worker in year four and each year thereafter. Each hourly worker will work 1900 hours per year. The average hourly wage will be $22.50 in year one. The plant will employ 9 supervisors in year one at an average salary of $85,000 each and 3 managers at an average salary of $210,000 each. In year three, the number of supervisors increases to 12. All wages and salaries are estimated to increase 3% annually. The plant's share of corporate services (accounting, auditing, planning and budgeting) is allocated at 4% of the annual dollar amount of sales.
Extensive advertising is needed to promote cereal sales. The advertising budget has been set at $8,000,000 in years one and two, and $5,000,000 in year three and each year thereafter.
The plant's production manager has determined the costs of retooling required to begin production. The cost of building wheat storage facilities is $7,000,000. New flake stamping equipment will cost $26,000,000. All new equipment and storage facilities will be depreciated over 10 years using straight line depreciation.
Transportation costs for each ton of raw materials arriving at the plant is $2,000 per ton. Transportation costs for each case of cereal shipped from the plant are $275 per 100 cases.
Accounts receivable will be 10% of annual sales. Inventory will be 12% of the cost of the ingredients used to produce the finished cereal product (wheat, sugar, and additives). Accounts payable will be 8% of the cost of the ingredients.
Alamo Cereal Company has a marginal tax rate of 34%. The firm's existing capital structure is considered optimal. The firm has 51,000 mortgage bonds outstanding at a coupon interest rate of 9.0%, par value of $1,000, and ten years to maturity. The current price of one mortgage bond is $1,040. The firm has 60,000 straight bonds outstanding at a coupon interest rate of 9.5%, and 12 years to maturity. The current price of one bond is $1,060. The firm has 2,800,000 shares of common stock outstanding. The current dividend is $6. Dividends are expected to grow at an annual rate of 4%. The current price of a share of stock is $45. The firm believes internally generated funds will be sufficient to maintain the firm's optimal capital structure without issuing additional common stock.
Assume at the end of year 10 the project is discontinued and sold for $5,000,000. Use an Excel spreadsheet to determine the cash flows from the project. Determine internal rate of return for the project. Using the information in the previous paragraph, determine the WACC and determine the net present value of the project using that WACC.
Should the company undertake this project? Explain.