FIN 571 Week 2 Estimating Cash Flows Example

What the Canning Line Really Adds: Incremental Cash Flows for Cascade Ridge's Non-Alcoholic Expansion, With Cannibalization, a Warehouse's Lost Rent, Tax Depreciation and Working Capital

[Student Name]

University of Phoenix

FIN/571: Corporate Finance

Week 2 Assignment

[Instructor Name]

[Date]

Cascade Ridge Beverage, the project and all figures are composites written for a model paper; methods and tax treatment are summarized generally from the sources listed.

Cascade Ridge Beverage, the composite Oregon craft beverage company from Week 1, plans a $9 million high-speed canning line to meet demand for its non-alcoholic beers. Its operations team prepared an analysis showing large profits from the new line. The chief financial officer asked for a full incremental cash flow estimate before the board vote. A project's value lies in what changes for the whole company if it goes ahead, and some of the biggest changes happen outside the project itself. This paper builds that estimate.

What Belongs and What Does Not

The test for every item is whether it changes when the board says yes rather than no (Brigham & Ehrhardt, 2022). Last year, Cascade Ridge spent $250,000 on a pilot study of non-alcoholic brewing methods. No decision made now can recover that spending, so it is a sunk cost and stays out of the analysis. Part of the purchase will be funded with a loan, yet the loan's interest stays out of the cash flows: the 10 percent hurdle rate already prices the money, and charging interest as well would bill the project for its funding twice.

The Initial Investment

The canning line, including installation and a pasteurizer for the non-alcoholic product, costs $9 million. Working capital, mostly cans, packaging and finished goods inventory plus receivables, is modeled as 12 percent of incremental revenue, building as sales grow.

Revenue and Contribution

Non-alcoholic sales are projected at $14 million in year one, $20 million in year two and $24 million in year three, then growing 3 percent a year. After ingredients, packaging, freight and distributor promotions, each dollar of non-alcoholic revenue contributes about 32 cents before fixed costs. Because beers under 0.5 percent alcohol by volume are not subject to the federal beer excise tax, their contribution is higher than that of comparable full-strength beer.

Cannibalization

Some customers who buy the non-alcoholic beer would otherwise have bought Cascade Ridge's regular beer. Market research and scanner data from the pilot suggest that about 10 percent of non-alcoholic revenue replaces company beer sales, on which the contribution is about 30 percent. In year three, that is about $2.4 million of lost beer revenue and about $720,000 of lost contribution a year, a real cost of the project.

The Warehouse's Opportunity Cost

The line will occupy part of a warehouse Cascade Ridge owns and currently uses for overflow storage of empty kegs and pallets, which can move to a yard area at little cost. A neighboring distillery has offered to rent that space for $180,000 a year. Building the line means giving up that rent, so the forgone income is an opportunity cost charged to the project.

Fixed Costs

The line adds about $2.4 million a year of fixed costs: a crew for two shifts, maintenance, quality testing and brand marketing for the non-alcoholic line. Marketing is included because the forecast sales depend on it; dropping it to flatter the project would leave the revenue forecast without support.

Tax Depreciation

Brewing and packaging equipment generally falls into the seven-year class under the federal tax depreciation system, with rates of about 14.3, 24.5, 17.5, 12.5, 8.9, 8.9, 8.9 and 4.5 percent over eight years. Depreciation is not a cash outflow, but it reduces taxable income, saving cash at the 26 percent combined tax rate (Ross et al., 2022). Current federal law also allows immediate expensing of qualifying equipment, which would move the tax savings earlier and raise the project's value; the base case uses the seven-year schedule as the more conservative assumption.

Operating Cash Flow

Each year's operating cash flow equals contribution, minus lost beer contribution, minus fixed costs and the forgone rent, minus depreciation, all after tax, plus depreciation added back. In year three, contribution of $7.68 million less $0.72 million of cannibalization, $2.4 million of fixed costs, $0.18 million of rent and $1.57 million of depreciation gives operating profit of about $2.81 million. After tax, about $2.08 million, plus depreciation, gives about $3.65 million, from which the $0.48 million increase in working capital is subtracted.

Terminal Cash Flow

In year eight, the line is expected to sell for about $1.5 million. Being fully depreciated, the whole amount is a taxable gain, leaving about $1.11 million after tax. Working capital of about $3.3 million is recovered as inventory and receivables run down.

The Cash Flow Table

Free cash flows after the $9 million outlay are about negative $0.25 million in year one, as working capital builds, then about $2.24 million, $3.17 million, $3.60 million, $3.67 million, $3.84 million and $4.00 million in years two through seven, and about $8.52 million in year eight including the terminal flows.

Net Present Value

At a 10 percent discount rate, reflecting the project's risk as a new product line, the project adds about $7.9 million of value, and its cash flows imply a return of roughly 24 percent a year.

Testing the Forecast

The project's value is sensitive to two assumptions. If non-alcoholic revenue reaches only 80 percent of the forecast, contribution falls by about a fifth and the net present value drops to roughly $3 million, still positive. If cannibalization proves to be 20 percent of revenue rather than 10, the value falls by about $2.7 million. A combination of slower sales and heavier cannibalization would leave the project worth less than $1 million, close to break-even. The pilot's scanner data, which tracked purchases at 40 grocery stores for six months, give some comfort on cannibalization, but the revenue forecast rests on a category that has grown fast for only a few years.

Immediate Expensing as an Alternative

If Cascade Ridge deducts the full $9 million in the first year under current federal law, it saves about $2.3 million of tax in year one instead of spreading savings over eight years. At a 10 percent discount rate, that timing gain adds roughly $0.5 million to the net present value. The company will decide with its tax adviser, since expensing also affects state taxes and next year's estimated payments.

What the Subtle Items Are Worth

Leaving out cannibalization and the forgone rent would have overstated the net present value by about $3.4 million, more than 40 percent of the correct figure. Kaplan and Ruback (1995) found that discounted cash flow valuations performed well when built on careful cash flow forecasts, which suggests that the quality of the forecast, not the method, is what matters most.

Conclusion

The canning line's incremental cash flows exclude the sunk pilot study and interest and include lost beer sales, forgone rent, tax depreciation, working capital and after-tax salvage. On that basis the project is worth about $7.9 million at a 10 percent rate. The operations team's figure was too high not because of its revenue forecast, but because it left out costs that occur outside the project itself.

References

Brigham, E. F., & Ehrhardt, M. C. (2022). Financial management: Theory and practice (17th ed.). Cengage.

Kaplan, S. N., & Ruback, R. S. (1995). The valuation of cash flow forecasts: An empirical analysis. The Journal of Finance, 50(4), 1059-1093. https://doi.org/10.1111/j.1540-6261.1995.tb04050.x

Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. D. (2022). Corporate finance (13th ed.). McGraw Hill.