The Pear Case - Burton Flynn

In the write-up state carefully any assumptions that you make in order to be able to solve the problem.

The Pear Company is thinking of building a new plant to put the pears it grows into cans. The plant is expected to last for 20 years. Its initial cost is $60 million. This cost can be depreciated over the full 20- year of the plant using straight line depreciation. It will require a major renovation which will cost $8 million in real terms after 12 years. This cost of renovation can be depreciated also using straight line depreciation over the remaining 8 years of the plan's life. The land the plant is built on could be rented out for $600,000 a year in nominal terms for 20 years. The salvage value of the plant at the end of the 20 years is $5 million in nominal terms. There is no salvage value with regard to the renovation.

The plant could be able to produce 60 million cans of pears a year. The price of a can of pears is currently $0.60. It is expected to grow at a rate of 2% per year in real terms for 8 years and then at 0% in real terms for the reminder of the plant's life. The firm expects to be able to sell all the cans of pears it can produce. The pears the firm puts in the cans are grown in the firm's own orchards. If the pears were not canned they could be sold to supermarkets. The current price they could obtain per pear is $0.15. This price is expected to grow at a rate of 3% in real terms for 5 years and then at 2% in real terms for the next five years and finally at 1% in real terms for the reminder of the plant's life. Each can requires pears to fill it. The raw materials for the cans currently cost $0.05 per can. These costs are expected to remain constant in real terms. The labor required to operate the plant costs a total of $7 million a year in real terms. Initially, the plant will require an additional $10 million of inventory, $10 million of accounts receivable, and $5 million of accounts payable. Working capital is expected to remain constant in real terms.

The rate of inflation is expected to be 3% per year for the next six years and 2% per year for the remainder of the plant's life. The firm's total tax rate including local taxes is 40%. The firm expects to make substantial profits on its other operations so that if it can offset any losses on the pear canning plant for tax purposes. Its opportunity cost of capital for projects of this type is 12% in nominal terms.

1. Build a spreadsheet in Excel to analyze the cash flows for this project. Should the firm build the plant? Why?

2. Please explain what was done and state carefully any assumptions that you make in order to be able to solve the problem.

3. After completing your analysis in nominal terms, build a second spreadsheet in real terms (in a another tab in the same file). The value of the real and nominal NPVs should be the same.

4. Which assumptions stated in the case (or your own) is the attractiveness of this project most heavily dependent on? How sensitive are they?

5. How much of the value of the project is due to the depreciation tax shield? If this seems high or low, what factors influence it?