A.

Define the term "incremental cash flow," Since the project will be financed in part by debt,
should the cash flow statement include interest expenses? Explain.
Incremental cash flow is the change (positive or negative) in the operating cash flow as a result of
undertaking a new project. Therefore, interest expense should not be included. This is a financing cost
(cost of capital), not an operating cost. Interest expense is already accounted for in the WACC (weighted
average cost of capital).

B. Should the 300,000 that was spent to rehabilitate the plant be included in the analysis?
$300,000 that was already spent last year to rehabilitate the plant is a sunk cost. Whether the proposal to
introduce a new wine in the product line is accepted or not, the amount of $300,000 cannot be recovered.
As a thumb rule sunk costs are not included in capital budgeting decisions.

C. Suppose another winemaker had expressed an interest in leasing the wine production site for
$30,000 per year. If this were true (in fact it was not), how would that information be incorporated
into the analysis?
If the information regarding offer of lease of the site is true, the lease rental of $30,000 per year is the
opportunity cost. The amount of $30,000 per year should be included in the analysis as annual cash
outflow (cost).

D. What is Robert Montoya's Year 0 net investment outlay on this project? What is the expected
non-operating cash flow when the project is terminated in year 4?

The initial cash outlay is $2,500,000 – in which $100,000 is the net working capital
Net Investment Outlay
Year 0
Estimated cost of new machinery $ 2,200,000
Shipping cost 80,000
Installation cost 120,000
Increase in working capital (Increase in inventory) 100,000
Initial fixed assets cost (Initial Outlay) $ 2,500,000

The non-operating cash flow in year 4 is $190,000. $100,000 is the recovery of net working capital and
$30,000 is the after-tax salvage value.
Non-Operating Cash Flow (Year 4)
Year 4
Before tax salvage value $ 150,000
After tax salvage value ($50,000*(1-0.40)) 90,000
Recovery of additional working capital 100,000
Initial fixed assets cost (Initial Outlay) $ 190,000
E. Estimate the project's operating cash flows. What are the project's NPV, IRR, modified IRR
(MIRR), and payback? Should the project be undertaken?

The project should not be undertaken since the NPV is negative. Also, MIRR and IRR are below than the
weighted average cost of capital which is defined as 10%.

WACC = Wd kd (1-T) + Ws ks = 0.5 (10%)(0.6)+0.5(14%) = 10%

Year 0 Year 1 Year 2 Year 3 Year 4

Estimated cost of new machinery $ 2,200,000
Shipping cost 80,000
Installation 120,000
Initial fixed assets cost (equipment) $ 2,400,000
Salvage value after 4 years $ 150,000

MACRS rate 0.33 0.45 0.15 0.07

Quantity (expected sales) 100,000 100,000 100,000 100,000
Wholesale price per bottle $ 40 $ 40 $ 40 $ 40
Operating cost per bottle 32 32 32 32

Sales 4,000,000 4,000,000 4,000,000 4,000,000

Less: Cost 3,200,000 3,200,000 3,200,000 3,200,000
Less: Net effect on introducing new wine 20,000 20,000 20,000 20,000
Less: Depreciation 792,000 1,080,000 360,000 168,000
Earnings Before Interest and Tax (EBIT) $ (12,000) $ (300,000) $ 420,000 $ 612,000
Less: Tax (at 40%) (4,800) (120,000) 168,000 244,800
Net Income $ (7,200) $ (180,000) $ 252,000 $ 367,200
Add: Depreciation 792,000 1,080,000 360,000 168,000
Operating cash flow $ 784,800 $ 900,000 $ 612,000 $ 535,200
Change in fixed assets (2,400,000) 90,000
Change in working capital (100,000) 100,000
Net cash flow $ (2,500,000) $ 784,800 $ 900,000 $ 612,000 $ 725,200

Cumulative cash flows $ (2,500,000) $ (1,715,200) $ (815,200) $ (203,200) $ 522,000

Payback Period (in years) 3.28

Net Present Value $ (87,617.79)

IRR 8.32%
MRR 9.02%