Production facilities for the new wine would be set up in an unused section of Wine Time' main plant. New machinery with an estimated total cost of $5,000,000 would be purchased. Furthermore, Wine Time' inventories (the new product requires aging in oak barrels made in France) would have to be increased by $600,000. This cash flow is assumed to occur at the time of the initial investment. The machinery has a remaining economic life of 5 years, and the company has obtained a special tax ruling that allows it to depreciate the equipment under the MACRS 5-year class life. MACRS depreciation percentages can be found in Appendix 12A of your textbook. The machinery is expected to have a salvage value of $450,000 after 5 years of use.

The section of the plant in which production would occur had not been used for several years and, consequently, had suffered some deterioration. Last year, as part of a routine facilities improvement program, $500,000 was spent to rehabilitate that section of the main plant. Earnie Jones, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the wine project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $500,000 to make the plant suitable for the wine project.

Wine Time's management expects to sell 70,000 bottles of the new wine in year 1 followed by annual sales of 120,000 for each of the following 4 years, at a wholesale price of $41 per bottle, but $25 per bottle would be needed to cover cash operating costs. In examining the sales figures, Sharpe noted a short memo from Wine Time's sales manager which expressed concern that the wine project would cut into the firm's sales of other wines-this type of effect is calledcannibalization. Specifically, the sales manager estimated that existing wine sales would fall by 5 percent if the new wine were introduced. Sharpe then talked to both the sales and production

managers and concluded that the new project would probably lower the firm's existing wine sales by $200,000 per year, but, at the same time, it would also reduce production costs by $125,000 per year, all on a pre-tax basis. Wine Time's federal-plus-state tax rate is 25 percent, and its overall cost of capital is the weighted average cost of capital from #7 from Part I of this case.

Now assume that you are Sharpe's assistant and she has asked you to analyze this project, and then to present your findings in a "tutorial" manner to Wine Time's executive committee. As financial vice president, Sharpe wants to educate some of the other executives, especially the marketing and sales managers, in the theory of capital budgeting so that these executives will have a better understanding of capital budgeting decisions. Therefore, Sharpe wants you to ask and then answer a series of questions as set forth next. Keep in mind that you will be questioned closely during your presentation, so you should understand every step of the analysis, including any assumptions and weaknesses that may be lurking in the background and that someone might spring on you in the meeting.

What is Wine Time's Year 0 total initial investment outlay on this project?

Estimate the project's operating cash flows for years 1 through 5.

What is the expected non-operating (terminal) cash flow when the project is terminated at the end of Year 5?

Using your WACC from Part I, what is the project's NPV and IRR? Should the project be undertaken?

Now, assume WT has enough operating income to write off (deduct) or expense the $3,000,000 project cost at the beginning of the project (time period 0) under current tax laws. This would lead to an up-front tax deduction and no depreciation on an annual basis during the life of the project.

Redo the cash flow estimates from questions 1, 2, and 3 under the full immediate expensing of the project cost allowed under the new tax laws.

What is the project's NPV and IRR under the new tax laws? Should the project be accepted?

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