Marques Gourmet Coffee Jose Ricardo Marques from San Pedro, Brazil is a fourth g
ID: 2739326 • Letter: M
Question
Marques Gourmet Coffee
Jose Ricardo Marques from San Pedro, Brazil is a fourth generation coffee plantation grower. Jose's great grandfather, Manual, started with 1,000 acres of coffee bean trees in the fertile valley of Brazil in the early 1900s. Through careful harvesting and production processes, Manual was able to develop a high quality premium coffee bean, which is used in the finest quality coffee blends. The family now owns close to 50,000 acres of coffee trees and is a major supplier to national companies specializing in gourmet coffee brands.
As Marques Coffee Beans has moved through the generations, family members have assumed various roles in the company operations. Jose, who grew up with the business, went to the Unites States for his college undergraduate degree and stayed on to earn an MBA degree with an emphasis in entrepreneurial studies. His goal has always been to start his own coffee company in the United States.
Once Jose finished his college training and earned his masters degree, the family gave him $1,000,000 to establish his business. Jose decided to locate in New Orleans, which was reasonably close to his supply link of coffee beans with direct air connections to his family farms in San Pedro. Jose also thought the New Orleans area, with its reputation for quality foods, would be an excellent local market to introduce his new gourmet coffee.
Jose was considering three different approaches to get his coffee brand produced and marketed in the New Orleans area. In the first option, he wanted to tie into the current cultural music fad and identify his coffee brand with the local music artists that were popular at the time. Jose felt that he could get immediate success with large levels of sales in the first two years, but as the fad dies off, his coffee sales would also decline. By the end of five years, he may have to develop a new brand or at least change the name of the current brand. This option has some risks as Jose would have to invest a lot of resources and time immediately to get acceptance of his coffee. He would have to quickly develop an efficient production system, which would also provide a high quality product desired by a wide diversity of users.
A second option Jose was considering was a go-slow approach and develop a coffee brand which would tie in with the scheduled Pan American games in four years. Brand sales would peak in the fourth and fifth years and possibly decline after the games are over. This option also had some risks. While it was not as critical to get the production operations quickly up and running and capturing a market, there was still a considerable cost in initial product development and a commitment to high quality. There was also some risk that the coffee brand would not gain the large market needed for overall success.
The third option was to just produce a gourmet coffee brand without any connection to a cultural fad or event. Sales would be aimed at a smaller segment of a target market with the idea of building up a gradual loyal following. This option probably has the least amount of risk if a general level of acceptance could be obtained. Changes could be made throughout the time period to refine the production process and product quality. There would not be the need for as large an expenditure of resources either at the start of the five-year cycle or at the end of the time period.
Jose wanted to consider the potential returns for each of these three options over a five-year time period. In using a more conservative approach, he wants to assume that the entire $1,000,000 of up front money would be required at the start of the operation. $800,000 would be used for equipment purchases, which would be subject to depreciation at $100,000 per year. The other $200,000 would be for working capital requirements. Jose is fully anticipating that the business will be successful and he will be continuing the operation for many years to come. However, for purposes of this analysis he decided to assume that at the end of 5 years he would terminate the coffee production operations and sell all the equipment for 10% of its original value.
Jose developed the following tables for projected revenues and operating costs for each of the next five years for each of the three options he was considering.
Projected Revenues
Years 1 - 5
Dollars in 1,000s
Year
Option 1
Option 2
Option 3
1
$800
$200
$600
2
$1,300
$400
$700
3
$800
$800
$800
4
$500
$1,500
$900
5
$300
$1,800
$1,000
Projected Operating Costs
Years 1 - 5
Dollars in 1,000s
Year
Option 1
Option 2
Option 3
1
$450
$150
$270
2
$650
$200
$300
3
$300
$350
$350
4
$150
$650
$400
5
$100
$750
$450
The projected tax rate for the company is 40%. Jose believes that any of these coffee brand strategies should bring an 18% return on investment.
Required:
Compute the initial outlay for each of these options.
Compute the annual cash flows for each of these options.
Compute the terminal value for each of these options.
Compute the net present value, profitability index, and internal rate of return for each of these options.
Identify other factors, which should be considered before deciding which coffee brand strategy, if any, should be selected.
Which option, if any, should be selected and why.
Year
Option 1
Option 2
Option 3
1
$800
$200
$600
2
$1,300
$400
$700
3
$800
$800
$800
4
$500
$1,500
$900
5
$300
$1,800
$1,000
Explanation / Answer
1) INITIAL OUTLAY FOR EACH OF THE OPTIONS: Cost of equipment 800000 Working capital 200000 Initial outlay 1000000 Initial outlay is given as same for all the options. 2) ANNUAL CASH FLOWS: Option 1: 1 2 3 4 5 Revenues 800000 1300000 800000 500000 300000 Operating costs 450000 650000 300000 150000 100000 Depreciation 100000 100000 100000 100000 100000 EBIT 250000 550000 400000 250000 100000 Tax @ 40% 100000 220000 160000 100000 40000 After tax income 150000 330000 240000 150000 60000 Add depreciation 100000 100000 100000 100000 100000 Annual cash flows 250000 430000 340000 250000 160000 Option 2: 1 2 3 4 5 Revenues 200000 400000 800000 1500000 1800000 Operating costs 150000 200000 350000 650000 750000 Depreciation 100000 100000 100000 100000 100000 EBIT -50000 100000 350000 750000 950000 Tax @ 40% -20000 40000 140000 300000 380000 After tax income -30000 60000 210000 450000 570000 Add depreciation 100000 100000 100000 100000 100000 Annual cash flows 70000 160000 310000 550000 670000 Option 3: 1 2 3 4 5 Revenues 600000 700000 800000 900000 1000000 Operating costs 270000 300000 350000 400000 450000 Depreciation 100000 100000 100000 100000 100000 EBIT 230000 300000 350000 400000 450000 Tax @ 40% 92000 120000 140000 160000 180000 After tax income 138000 180000 210000 240000 270000 Add depreciation 100000 100000 100000 100000 100000 Annual cash flows 238000 280000 310000 340000 370000 3) TERMINAL VALUE FOR EACH OF THE OPTIONS: (Same for all three options: Sale of the equipment 80000 Tax shield on loss 88000 (300000 - 80000)*0.4 Release of working capital 200000 368000 4) NPV, PI and IRR for each of the options: Option 1: Annual cash flows 250000 430000 340000 250000 160000 pvif@18% 0.8475 0.7182 0.6086 0.5158 0.4371 PV 211864 308819 206934 128947 69937 Total PV of annual cash inlows 926503 PV of terminal cash inflow (368000*0.4371) 160856 PV of cash inflows for the option 1087359 Less: Initial investment 1000000 NPV 87359 $ PI = 1087359/1000000 = 1.087 IRR = 20 + 2*36458/(1036458-989269) = 21.55 % Workings for IRR: Cumulative Cash inflows incl. terminal CFs 250000 430000 340000 250000 528000 pvifa @ 20% 0.8333 0.6944 0.5787 0.4823 0.4019 PV 208333 298611 196759 120563 212191 1036458 pvifa @22% 0.8197 0.6719 0.5507 0.4514 0.3700 PV 204918 288901 187240 112850 195360 989269 Option 2: Annual cash flows 70000 160000 310000 550000 670000 pvif@18% 0.8475 0.7182 0.6086 0.5158 0.4371 PV 59322 114910 188676 283684 292863 Total PV of annual cash inlows 939454 PV of terminal cash inflow (368000*0.4371) 160856 PV of cash inflows for the option 1100310 Less: Initial investment 1000000 NPV 100310 $ PI = 1087359/1000000 = 1.100 IRR = 20 + 2*31231/(1031231-967923) = 20.99 % Workings for IRR: Cumulative Cash inflows incl. terminal CFs 70000 160000 310000 550000 1038000 pvifa @ 20% 0.8333 0.6944 0.5787 0.4823 0.4019 PV 58333 111111 179398 265239 417149 1031231 pvifa @22% 0.8197 0.6719 0.5507 0.4514 0.3700 PV 57377 107498 170719 248269 384059 967923 Option 3: Annual cash flows 238000 280000 310000 340000 370000 pvif@18% 0.8475 0.7182 0.6086 0.5158 0.4371 PV 201695 201092 188676 175368 161730 Total PV of annual cash inlows 928561 PV of terminal cash inflow (368000*0.4371) 160856 PV of cash inflows for the option 1089417 Less: Initial investment 1000000 NPV 89417 $ PI = 1087359/1000000 = 1.089 IRR = 20 + 2*32728/(1032728-980458) = 21.25 % Workings for IRR: Cumulative Cash inflows incl. terminal CFs 238000 280000 310000 340000 738000 pvifa @ 20% 0.8333 0.6944 0.5787 0.4823 0.4019 PV 198333 194444 179398 163966 296586 1032728 pvifa @22% 0.8197 0.6719 0.5507 0.4514 0.3700 PV 195082 188121 170719 153476 273059 980458 5) Selection: The values of NPV, PI and IRR for the three options are tabulated below: NPV PI IRR Option 1 87359 1.087 21.55 Option 2 100310 1.100 20.99 Option 3 89417 1.089 21.25 All the options are acceptable as they have positive NPVs, PI is greater than 1 and IRR>COC. As per NPV & PI Option 2 is ranked 1. As per IRR option 1 is ranked 1. But NPV is to be taken into account and hence Option 2 should be selected. NPV gives the absolute addition to Shareholders' wealth and hence should be the criteria.
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