Principles of Finance Case Study

CASE SUMMARY

Pilgrim Coffee Inc. is a successful chain of coffee shops that offers handcrafted coffee and espresso drinks using outsourced coffee beans. In their quest to deliver the best cup of coffee around, top management has learned a lot about coffee beans from around the world and are considering the task of roasting their own coffee beans in house at their flagship cafe. The managers believe they can wholesale their roasted coffee beans to other coffee shops (both local and afar) and offer their packaged beans to customers in-house as well as use the beans for their own drink creations. The COO is worried about the potentially high costs involved and would like to use your finance knowledge to evaluate the new venture and to address management’s concerns.

CASE OVERVIEW

The main equipment required is a commercial coffee bean roaster. Management has their eyes set on a vintage commercial roasting machine which costs $180,000. The shipping and installation cost of the machine is $40,000. The roasting machine will be depreciated under the MACRS system using the applicable depreciation rates which are 33%, 45%, 15%, and 7% respectively. Production is estimated to last for three years, and the company will exit the market before intense competition sets in and erodes profits. The market value of the coffee bean roaster is expected to be $120,000 after three years. Net working capital of $5,000 is required at the start, which will be recovered at the end of the project. The coffee beans will be packaged in 12 oz. containers that sell for $22.00 each. The company expects to sell 20,000 units per year; cost of goods sold is expected to total 70% of dollar sales.

Weighted Average Cost of Capital (WACC):

Pilgrim’s common stock is currently listed at $45 per share; new preferred stock sells for $50 per share and pays a dividend of $2.50. Last year, the company paid dividends of $1.50 per share for common stock, which is expected to grow at a constant rate of 10%. The local bank is willing to finance the project at 12.5% annual interest. The company’s marginal tax rate is 35%, and the optimum target capital structure is:

Common equity 50%
Preferred 20%
Debt 30%

Your main task is to compute and evaluate the cash flows using capital budgeting techniques, analyze the results, and present your recommendations whether the company should take on the project.

QUESTIONS

To help in the analysis, answer all the following questions as an accompaniment to your report to the owners. Present the analysis in one Excel file with the data, computations, formulas, and solutions. It is preferred that the Excel file be embedded inside the WORD document.

1. What is the total investment amount at the start of the project (i.e., year zero cash flow)?
2. Prepare a depreciation schedule to show the amount of depreciation for each year.
3. What is the after-tax salvage value of the equipment?
4. What is the projected net income and Operating Cash Flows (OCF) for the three years?
   • Complete an income statement for each year.
5. What are the Free Cash Flows (FCF) generated from the project?
   • Create a projected cash flow schedule
6. What is the Weighted Average Cost of Capital (WACC)?
   • Compute the after-tax cost of debt
   • Compute the cost of common equity
   • Compute the cost of preferred stock
   • Compute the Weighted Average Cost of Capital (WACC)
7. Using a WACC of 15%, apply four capital budgeting techniques to evaluate the project, assuming the Free Cash Flows are as follows:
   

   Years	Free Cash Flows
   0	($225,000.00)
   1	$107,725.00
   2	$116,125.00
   3	$169,000.00

   The four techniques are NPV, IRR, MIRR, and discounted Payback. Assume the reinvestment rate to be 8% for the MIRR. Also, assume that the business will only accept projects with a payback period of two and half years or less.

8. Which of the four techniques should be selected and why?

Present your findings in a report to the CEO with recommendations as to whether the project should be accepted or rejected based on the four criteria.

Your analysis should include a discussion of the decision-making rules for each method.