Analysis of Sullivan's new investment project: Fresh Papaya Juice

Sullivan’s management is currently evaluating a new product, fresh papaya juice.  The new product would cost more, but it is superior to the competing products.  As Sullivan’s financial analyst, you must analyze this project, along with two other potential investments, and then present your findings to the company’s executive committee.

Production facilities for the fresh papaya juice product would be set up in an unused section of Sullivan’s main plant.  Relatively inexpensive used machinery with an estimated cost of only $800,000 would be purchased, but shipping costs to move the machinery to Sullivan’s plant would total $70,000 , and installation charges would add another $92,000  to the total equipment cost.  Further, Sullivan’s inventories (raw materials, work-in-process, and finished goods) would have to be increased by $30,000 at the time of the initial investment.  The machinery has a remaining economic life of 6.00 years, and the company has obtained a special tax ruling that allows it to depreciate the equipment under the MACRS 3.00-year class.  Use the following depreciation schedule for your analysis:

The machinery is expected to have a salvage value of $40,000.00 after 6.00 years of use.

The section of the plant where the juice production would occur has been unused for several years, and consequently had suffered some deterioration.  Last year, as part of a routine facilities improvement program, Sullivan spent $100,000 to rehabilitate that section of the main plant.  Will Smith believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the papaya project.  His contention is that if the rehabilitation had not taken place, the firm would have to spend the $100,000 to make the site suitable for the papaya juice project.

Sullivan’s marketing department estimated that current annual demand for the papaya juice product would be            36,000 cartons of the new juice product, at a price of $14.00 per carton, but $11.00 per carton would be needed to cover fixed and variable cash operating costs.  However, marketing estimates that produce demand will increase by               7,000  cartons each year and that the price per carton will increase by 5.00% per year over the economic life of the project. Accounting estimated that operating costs will increase by 2.00% per year above current operating costs.  

In examining the sales figures, you note a short memo from Sullivan’s sales manager expressing concern that the fresh juice project would cut into the firm’s sales of frozen orange juice. Specifically, the sales manager estimated that orange juice concentrate sales would fall by 5 percent if fresh papaya juice were introduced.  You then talked to both the sales and production managers, and concluded that the new project would probably lower the firm’s orange juice concentrate sales by $69,000.00 per year, but at the same time, it would also reduce production costs for this product by $39,000.00 per year, all on a pre-tax basis. For simplification, no inflationary pressures are associated with the decrease in orange juice sales and reduced production costs

To evaluate the project, you have had access to the following information. 

1. Sullivan’s long-term debt consists of 7.00% coupon, semi-annual payment bonds with 18.00 years remaining to maturity.  The bonds traded last week at a price of $1,000.00 per $1,000 par value bond.  The bonds are not callable and are rated A.

2. Management has an aversion to short-term debt, so Sullivan uses such debt only to fund cyclical working capital needs.

3. Sullivan’s federal-plus-state tax rate is 42.00%.

4. The firm’s last dividend (Do) was $2.00 , and dividends are expected to grow at about a 1.00% rate in the foreseeable future.  Sullivan’s common stock now sells at a price of $46.00 per share.

5. The current yield on long-term T-bonds is 8.00%, and a prominent investment banking firm has recently estimated that the market risk premium is 4.00% over Treasury bonds.  The firm’s historical beta, as measured by several analysts who follow the stock, is 2.50.

6. The required rate of return on an average (A-rated) company’s long-term debt is 12.00%.

7. The optimal capital structure for Sullivan calls for 38.00% long-term debt and 62% equity financing.

You are asked to analyze the project, and then to present your findings in a “tutorial” manner to Sullivan’s executive committee.  The CEO wants you to educate some of the other executives, especially the marketing and sales managers, in the theory of capital budgeting so that these executives will have a better understanding of his capital budgeting decisions.  Therefore, you have decided to ask and then answer a series of questions as set forth below.  Specifics on the other two projects that must be analyzed are provided in Questions 7 and 8

1. What is Sullivan’s corporate cost of capital?  Is the cost of capital the same as the cost of debt?  Why or why not?

2. Define incremental cash flow, and then set forth the fresh papaya project’s operating cash flow statement for the first year of operation.  

3. Since the project will be financed in part by debt, should the cash flow statement include interest expenses?  Explain.

4. Should the $100,000 that was spent to rehabilitate the plant be included in the analysis?  Explain.

5. What is Sullivan’s Year 0 investment outlay on this project?  What is the expected nonoperating cash flow when the project is terminated?

6. What is the project’s estimated net cash flow stream?

7. What is the project’s NPV, IRR, and modified IRR (MIRR), margin of error and payback?  Should the project be undertaken? 

Depreciation: 

1 yr 33%

2 yr 45%

3 yr 15%

4 yr 7%