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Explain the risk and techniques associated with evaluating mutually excusive projects

Justify your choice of discount rate for the analysis

 

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This assignment is designed to introduce you to:

  • Construct a cash budget,
  • Risk/return analysis as a basis for making investment decisions,
  • Explain the risk and techniques associated with evaluating mutually excusive projects,
  • Financial planning and controlling operations, and
  • Additional research skills outside course materials/delivery

 

Rosanna Roses

Angelina and Brad established their business partnership ‘Rosanna Roses’ 5 years ago. Brad has a degree in horticulture and leaves the marketing and financing of the firm to Angelina as she has a Commerce degree.

The business has experienced a solid level of success growing roses for the cut-flower market. It is located on a 6-hectare property north of Hobart. Five hectares are currently under cultivation and Angelina and Brad have been discussing expanding the business by utilising the spare hectare. They have asked you to analyse the following data and provide them with a recommendation as to the acceptability of the project. Brad and Angelina tell you that they will retire 10 years from today. The business will not be sold as Angelina and Brad live on the property.

Brad has been developing three new varieties of roses over the last 2 years. Development costs of the roses so far has been $70000. Details of the new roses are as follows:

  • ‘Brittany’ has a large flamboyant pink flower. The rose bush is sturdy and well suited to commercial growing conditions. The Brittany is well suited to the temperate climate where Rosanna Roses operates, but it is not expected to do well in warmer climates.

 

  • ‘Taylor’ has been developed for its delightful fragrance. The rose bush is not as robust as the Brittany, but is expected to perform reasonably well under commercial growing conditions. It will require a lot of pruning to prevent it turning into a monster

 

  • ‘Madonna’ has a less exciting flower than the Brittany and a milder perfume than the Taylor, but it does have the advantage of longevity as a cut flower. It is a relatively low- maintenance rose bush to cultivate

 

Brad estimates that it will take 6 months for further development and testing of the new roses if the decision is made to expand the operation of Rosanna Roses with cultivation of these three roses. It would then take another 6 months to generate sufficient stock to plant a hectare of land. The operating cash outflow associated with the further development and stock production is $140000 and is tax deductible. The hectare of land that would be planted would need to be cleared, graded and cultivated. Angelina estimates that this would cost $20000. The soil would need to be enriched with 10 tonnes of manure at a cost of $100 per tonne. The clearing and fertilising costs are tax deductible. The clearing and fertilising of the land would occur the day before the new roses are taken from the green- house for planting out.

 

The time from planting to a commercial quantity of flower buds is 3 years after the roses are transferred from the greenhouse to the soil. After the roses are transplanted from the greenhouse to the soil, the labour cost per hectare of roses under cultivation is $10000 pa, pest control will cost a further $5000 pa and the annual fertiliser cost is $500 per hectare. Additional labour costs of $3000 pa are required when the roses are cut and packed in boxes for sale. The new project will utilise the existing cultivation equipment. This equipment was purchased 5 years ago for a total cost of $90000 and is being depreciated using the prime cost method over 10 years. It is used for all current projects. A marketing consultant was contracted 6 months ago to provide market research on the new rose varieties. Rosanna Roses received an invoice for $5000 and the following advice this week.

 

MEMO ONE

To: Rosanna Roses

From: Brilliant Marketing

Subject: Market response to the Brittany, Taylor and Madonna roses

At your request, we have conducted rigorous market research into the demand for your three new varieties of roses. Our results are as follows:

  • The large flowers and fashionable colours of the Brittany rose were well received by florists. Many commented that they had never seen a rose more suited to bridal bouquets, where the size and colour of the flowers are the critical features.

 

  • The fragrance of the Taylor makes this rose ideal for supermarket sales of cut flowers. Buyers for super markets commented Taylor bunches in stores would generate large sales as customers would be drawn to the stunning fragrance.

 

  • The Madonna rose was especially attractive to florists who specialise in funeral wreaths. The long-lasting flowers and sedate perfume of the Madonna are ideal characteristics for this market.

 

  • We conclude that each of the three new varieties of roses would fill market niches very successfully.

 

  • We have estimated how many boxes of 100 roses would be sold and the price per box for 10 years.

 

  • We also estimate that the new range of roses would reduce sales of your current product by $30000 per annum.

 

  • Initially, marketing expenses would be relatively high as we work to familiarise the market with the new roses. The charge for marketing your new products would be $20000 pa for the first 3 years of sales. The charge for subsequent years would be $4500 pa

chat

 

RosannaRoses currently usesBrilliantMarketing to advertise the firm’s existing range of roses. Angelina and Brad would contract Brilliant Marketing for the new project if they decide to adopt it. Brad is confident that the firm can supply as many boxes of roses as the market demands. Brad would need more greenhouse capacity to develop the new roses and grow them to the required size for planting. He has received the following quote for extending the current facilities to the size he needs.

 

MEMO TWO

To: Brad, Rosanna Roses

From: Glassy Greenhouses

Subject: Extension of greenhouse at Rosanna Roses

 

  • Thank you for asking us to provide the following quote to extend the facilities we built for you 5 years ago

 

  • The expansion of the greenhouse would require a cement slab equipped with appropriate drainage. We estimate that this would cost $35 000.

 

  • Materials for the structure would cost $60 000

 

  • Labour and associated insurance will cost $12 000.

 

The greenhouse cannot be depreciated for taxation purposes. In addition to the extension to the greenhouse, Brad would need racks for storing the roses while they grow. This equipment would cost $7000 and can be depreciated using the prime cost method over 3 years. A new drip watering system would also need to be installed at a cost of $6000. The watering system can be depreciated using prime cost over 4 years. Brad recently attended a conference about future trends in the rose growing business. At one of the sessions Brad heard a leading rose market researcher discussing a change in the home gardening market for rose bushes. While 90% of current rose bush sales in the home gardening market are for bare rooted plants about 12 months old, the researcher expects a very strong growth in the market for more mature roses in pots. Brad thinks that the Brittany, Taylor and Madonna varieties would do well in this new market. Given the different qualities of each rose, Rosanna Roses would be able to capture a large share of the potted rose market. He expects that each of the 1000 roses that would be planted on the spare hectare of land could be sold for $50 in 7 years from the commencement of the project. The costs of growing the roses up to this point would be the same as they are for the cut- flower market and the flowers could be sold until the rose bushes are transferred to pots for sale. The rose bushes would be harvested after flowering has finished for the year. The bushes would be presented in pots that would appeal to the upper end of the market and each pot would cost $10.

Rosanna Roses currently uses Quickest Couriers to deliver their flowers. Angelina requested a quote for freight rates and received the following from the couriers.

 

MEMO THREE

To: Angelina and Brad, Rosanna Roses

From: Quickest Couriers

Subject: Quote for delivery of boxes of roses

 

We have received your request for a quote to expand your current delivery contract. We are pleased to be able to continue to offer you the fixed rate of $25 per box. The delivery price for potted roses will be $4 per pot. We look forward expanding our happy business relationship with Rosanna Roses

Angelina has provided the following information about the firm’s cost of capital:

  • The before-tax cost of capital is 15.25%.
  • The after-tax cost of capital is 10.75%.
  • The rate of return on Treasury Bills is 6.5%.
  • The company’s after-tax cost of debt is 8%.

 

New projects with similar risks as existing projects are evaluated at the cost of capital. Any new projects that have different characteristics to the current Rosanna Roses projects (that is, those that do not involve growing roses) would be evaluated using a risk-adjusted discount rate. A further 7% would be added to the cost of capital for projects that do not involve growing roses. Brad and Angelina both have a marginal tax rate of 42%. The corporate tax rate is 30%.

Assume that any tax losses from this project can be used to offset tax payable on other operations conducted by Rosanna Roses.

Angelina and Brad have asked to you advise them on the acceptability of the project.

They have requested that you use the NPV and IRR approaches

 

REQUIRED

l. Advice Angelina and Brad on their decision about accepting or rejecting the project.

Show all equations and calculations.

 

2. To support your calculations in (1), prepare a justification of the cash flows you have used in your analysis. That is, you should identify why you have included each cash inflow and outflow to arrive at your net cash flows. If you have omitted cash flows discussed in the information provided, you should also explain why these have not been used in the analysis.

 

3. Justify your choice of discount rate for the analysis.

 

4. Currently, Rosanna Roses is structured as a partnership. Brad and Angelina are thinking about listing the firm on the ASX if this project is successful. They have asked you to explain the impact (if any) that listing would have on the capital budgeting process. Write a short essay to advise them on this matter.

 

5. Include a reworked analysis of the project (that is, repeat requirement 1) assuming Rosanna Roses is structured as a company that is fully integrated with the dividend imputation system. Show all calculations.

 

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