Robert Montoya, Inc., is a leading producer of wine in theUnited States. The firm was founded in 1950 by Robert Montoya, anAir Force veteran who had spent several years in France both beforeand after World War II. This experience convinced him thatCalifornia could produce wines that were as good as or better thanthe best France had to offer. Originally, Robert Montoya sold hiswine to wholesalers for distribution under their own brand names.Then in the early 1950s, when wine sales were expanding rapidly, hejoined with his brother Marshall and several other producers toform Robert Montoya, Inc., which then began an aggressive promotioncampaign. Today, its wines are sold throughout the world.

           The table Wine market has matured and Robert Montoya's wine coolersales have been steadily decreasing. Consequently, to increasewinery sales, management is currently considering a potential newproduct: a premium red wine using the cabernet sauvignon grape. Thenew wine' is designed to appeal to middle-to-upper-incomeprofessionals. The new product, Suave Mauve, would be positionedbetween the traditional table wines and super premium table wines.In market research samplings at the company's Napa Valleyheadquarters, it was judged superior to various competing products.Sarah Sharpe, the financial vice president, must analyze thisproject, along with two other potential investments, and thenpresent her findings to the company's executive committee.

           Production facilities for the new wine would be set up in an unusedsection of Robert Montoya's main plant. New machinery with anestimated cost of $1,800,000 would be purchased, but shipping coststo- move the machinery to Robert Montoya's plant would total$80,000, and installation charges would add another $120,000 to thetotal equipment cost. Furthermore, Robert Montoya's inventories(the new product requires aging for 5 years in oak barrels made inFrance) would have to be increased by $100,000. This cash flow isassumed to occur at the time of the initial investment. Themachinery has a remaining economic life of 4 years, and the companyhas obtained a special tax ruling that allows it to depreciate theequipment under the MACRS 3-year class life. Under current tax law,the depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in Years1 through 4, respectively. The machinery is expected to have asalvage value of $200,000 after 4 years of use.

           The section of the plant in which production would occur had notbeen used for several years and, consequently, had suffered somedeterioration. Last year, as part of a routine facilitiesimprovement program, $300,000 was spent to rehabilitate thatsection of the main plant. Earnie Jones, the chief accountant,believes that this outlay, which has already been paid and expensedfor tax purposes, should be charged to the wine project. Hiscontention is that if the rehabilitation had not taken place, thefirm would have had to spend the $300,000 to make the plantsuitable for the wine project.

           Robert Montoya's management expects to sell 125,000 bottles of thenew wine in each of the next 4 years, at a wholesale price of $50per bottle, but $30 per bottle would be needed to cover cashoperating costs. In examining the sales figures, Sharpe noted ashort memo from Robert Montoya's sales manager which expressedconcern that the wine project would cut into the firm's sales ofother wines-this type of effect is called cannibalization.Specifically, the sales manager estimated that existing wine saleswould fall by 5 percent if the new wine were introduced. Sharpethen talked to both the sales and production managers and concludedthat the new project would probably lower the firm's existing winesales by $60,000 per year, but, at the same time, it would alsoreduce production costs by $40,000 per year, all on a pre-taxbasis. Thus, the net externality effect would be -$60,000 + $40,000= -$20,000. Robert Montoya's federal-plus-state tax rate is25 percent, and its overall cost of capital is 10percent, calculated as follows:

                                   WACC = W_d r _d (1-T) +W_sr_s

                                               = 0.5(10%) (0.6) + 0.5(14%)

                                               = 10%.

           Now assume that you are Sharpe's assistant and she has asked you toanalyze this project, along with two other projects, and then topresent your findings in a "tutorial" manner to Robert Montoya'sexecutive committee. As financial vice president, Sharpe wants toeducate some of the other executives, especially the marketing andsales managers, in the theory of capital budgeting so that theseexecutives will have a better understanding of capital budgetingdecisions. Therefore, Sharpe wants you to ask and then answer aseries of questions as set forth next. Keep in mind that you willbe questioned closely during your presentation, so you shouldunderstand every step of the analysis, including any assumptionsand weaknesses that may be lurking in the background and thatsomeone might spring on you in the meeting.

A. Define the term "incremental cash flow," Since the projectwill be financed in part by debt, should the cash flow statementinclude interest expenses? Explain.

B. Should the 300,000 that was spent to rehabilitate the plantbe included in the analysis?

C. Suppose another winemaker had expressed an interest inleasing the wine production site for $30,000 per year. If this weretrue (in fact it was not), how would that information beincorporated into the analysis?

D. What is Robert Montoya's Year 0 net investment outlay on thisproject? What is the expected nonoperating cash flow when theproject is terminated in year 4?