Indian River

4

Risk Analysis in

Capital Budgeting

Indian River Citrus Company (B)

In Case 12, Lili Romero and Brent Gibbs analyzed a lite orange juice project for the Indian River Citrus Company. The project required an initial investment of $580,000 in fixed assets (including shipping and installation charges), plus a $10,000 addition to net working capital. The machinery would be used for 4 years and be depreciated on the basis of a 3-year MACRS class life. The appropriate MACRS depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively, and the machinery is expected to have a salvage value of $100,000. If the project is undertaken, the firm expects to sell 440,000 cartons of lite orange juice at a current dollar (Year 0) wholesale price of $2 per carton. However, the sales price will be adjusted for inflation, which is expected to average 3 percent annually, so the actual expected sales price at the end of the first year is $2.06, the expected price at the end of the second year is $2.1218 and so on. Salvage value of the equipment is $100,000.

The lite orange juice project is expected to cannibalize the before-tax profit Indian River earns on its regular orange juice line by $20,000, because the two product lines are somewhat competitive. Further, the company expects cash operating costs to be $1.50 per unit in Time 0 dollars, and it expects these costs to increase by 2 percent per year. Therefore, total operating cash costs during the first year of operation (Year 1) are expected to be ($1.50) (1.02) (440,000) = $673,200. Indian River's tax rate is 40 percent, and its cost of capital is 10 percent.

When Lili and Brent presented their initial analysis to Indian River’s executive committee, things went well, and they were congratulated on both their analysis and their presentation. However, several questions were raised. In particular, the executive committee wanted to see some type of risk analysis on the project – it...