SCHOOL OF BUSINESS AND LAW

Assignment
Semester 1, 2017

ECF6110 BUSINESS FINANCE

DUE: Week 10 (8 May 2017)

You are required to attempt the case study Wellness Drinks Company which accounts for
25% of the assessment for this unit. The objective of this assignment is to allow you to apply
the theories, principles and techniques that you have learned in class to analyse a business
situation. The information presented in the case is generally sufficient for you to develop an
understanding of the situation. It is important to demonstrate your knowledge of financial
concepts and tools in analysing the case.
The assignment is be completed in a group of two to three persons. Please ensure that
individual names and student ID numbers of your group members are recorded in the
Assignment Cover Sheet. The following rules will apply to group work:
Each member of the team is to use the Sign-Up Sheet under Groups in the
Grades & Tools tab on Blackboard to join the same group from the given list.
Every member in the group is expected to attend the group meetings and contribute
his/her share of the Assignment work in a timely manner.
Should team conflict issues arise then they need to be resolved prior to submission.
Ability to collaborate and work in a team is part of the learning outcomes and
graduate attributes.
Only in cases where every effort has been made to resolve any problems should the
lecturer be asked to intervene.

Submission information
1. A hard copy of the Assignment including the Assignment Cover Sheet is to be submitted
to your lecturer at the beginning of your lecture in Week 10, Monday, 8 May 2017.
2. An electronic copy of the Assignment that does not include the Assignment Cover Sheet
is to be submitted online to both the Group Assignment and the Turnitin Assignment
on Blackboard before 7:00 pm, 8 May 2017.
3. One online submission per group so only one student from the group can submit the
Assignment to Turnitin. A penalty of 5% off your groups awarded marks will be
applied if two students from the same group submitted the same Assignment to Turnitin.
Late submission will attract a penalty as per University guidelines. A penalty of 5% of the
maximum assignment mark for each working day late; and more than five working days late,
a mark of zero for the assignment.

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Grading:
Your assignment will be graded on the standard of presentation, good understanding and
logical arguments in analysing the problems, and accuracy in deriving the solutions.

Extensions:
Requests for extensions must be made in writing before the due date. Requests for extensions
on the grounds that you have other assignments due at the same time are very unlikely to be
granted. Requests for extensions after the due date must be accompanied by a medical
certificate.

Length:
There are no specific word limits; however, the report including the Appendices should not
be more than 20 pages. Answers are expected to be literate and coherent.

Presentation:
Work should be typed in 1.5 line spacing with reasonably wide margins for comments.

Referencing:
You must include in-text referencing where appropriate and all assignments should have a
bibliography. All referencing should be in accordance with the University Referencing Guide,
which is available from the ECU Bookshop or online from the ECU Library homepage.

Academic Misconduct and Plagiarism

Edith Cowan University regards academic misconduct of any form as unacceptable. If some
form of academic misconduct has been committed then an appropriate penalty will be applied
as outlined in Statute 22 and Rule 40 of the ECU Handbook.
Please note that Turnitin will check your submitted Assignment for improper citation or
potential plagiarism by comparing against the academic database and other students work. If
your Turnitin report has a similarity index of more than 35%, everyone in your group will be
reported to the Associate Dean of Teaching and Learning for alleged academic misconduct.

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 CASE STUDY
Wellness Drinks Company

Please read the case of Wellness Drinks Company before starting this assignment.

Your task as a financial analyst is to prepare a capital budgeting report to Mr Harvey and
executive committee of Wellness Drinks Company indicating whether the company should
accept or reject the lemonade project, including the replacement decision. Your report should
include the answers to the following Questions 1 to 7. It is important to list your assumptions
in applying the investment evaluation techniques, and show clearly the workings and
calculations in deriving your results. Your assignment will be graded based on presentation,
understanding of the issues and logical explanation, and accuracy of calculations in solving
the problems. The mark allocations for individual questions (including 20 marks for
presentation) will total to 125 marks and will be scaled by a factor of 0.2 to produce a mark
consistent with 25% weighting in the unit assessment.

QUESTIONS

1. Prepare the cash flow table (which incorporates taxes and includes initial investment,
operating and terminal cash flows) for the fresh lemonade project based on the most
likely annual sales quantity of 250,000 cartons. For simplicity, assume no other cash
flows apart from the sales price and cash operating costs are affected by inflation.
Explain if each of the following items should be included in the cash flow statement:
a) The interest expenses on the machinery cost financed by a 12% term loan over four
years;
b) Initial investment of $60,000 on inventories and 10% of annual sales revenue in
subsequent years;
c) The $80,000 that was spent to rehabilitate the plan;
d) The reduction in Wellnesss frozen lemonade sales and associated production
costs;
e) Opportunity of leasing the lemonade production site for $24,000 per year.
[32 marks]

2. Consider all information given in the case and Question 1, what are the payback period,
net present value (NPV), internal rate of return (IRR) and profitability index (PI) of this
project? Assume the company uses a payback rule with cut-off period of three years.
Should the project be undertaken based on each of the investment evaluation methods?
[11 marks]

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3. Assume the sales quantity estimate remains at 250,000 cartons per year, what is the
break-even annual net cash inflow for the project? Now assume that the sales price
remains at $4.00, and the fixed and variable operating costs are fixed at $2.80 per carton.
What annual unit sales volume would be needed for the project to break even? [You may
ignore the effects of inflation and tax savings on depreciation.]
[8 marks]

4. Show a sensitivity analysis of NPV to sales quantity (worst- and best-case scenarios) and
cost of capital. Assume each of these variables can deviate from its expected value by
plus or minus 20%.
[15 marks]

5. Use the NPVs for the worst-, most-likely- and best-cases of sales quantity estimates (i.e.
the figures derived in Questions 2 and 4), and their probabilities of occurrence to find
the projects expected NPV, standard deviation, and coefficient of variation.
[6 marks]

6. Assess the risk of the fresh lemonade project using the results derived in Questions 3, 4
and 5. Would the project be classified as high risk, average risk, or low risk? Explain.
[10 marks]

7. If the fresh lemonade project is a success, should Wellness replace the used machinery
in two years or four years time under normal market condition (i.e. based on annual
sales quantity of 250,000 cartons)? Justify your answer. Assume the company is able to
acquire the new machinery on the same terms indefinitely, other replacement options are
to be ignored, and all revenue and cost figures remain the same.
[23 marks]

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 CASE STUDY
Wellness Drinks Company1

Wellness Drinks Company was formed in 1985 and is a leading producer of fresh, frozen, and
made-from-concentrate citrus drinks in Australia. The founder of the company, Mr Charles
Harvey, invested his money in citrus land located in south-west region of Western Australia.
Mr Harvey originally sold his oranges and grapefruit to wholesalers for distribution to grocery
stores. When juice sales were expanding, he joined with several other producers to form
Wellness Drinks Company, which then expanded into juice processing. By 2015 the company
had a sales turnover of over $10 million with profits in excess of $1 million.

Wellnesss management is currently evaluating a new product, fresh lemonade. The new
product would cost more, but it is superior to the competing lemonade products made from
reconstituted lemon juices. As a recent business school graduate working at Wellness as
financial analyst, you must analyse the project, and then present the findings to the companys
executive committee.

Production facilities for the fresh lemonade product would be set up in an unused section of
Wellnesss main plant. Relatively inexpensive used machinery with an estimated cost of
$500,000 would be purchased, but shipping costs to move the machinery to Wellnesss plant
would total $20,000, and installation charges would add another $30,000 to the total
equipment cost. Further, inventories (raw materials, work-in-progress, and finished goods)
would have to be increased by $60,000 at the time of initial investment. Thereafter, inventories
requirement is estimated to represent 10% of annual sales revenue. The machinery has a
remaining economic life of 4 years, and the company has obtained a special tax ruling that
allows it to depreciate by 40%, 30%, 20% and 10% in Years 1 through 4, respectively. The
machinery is expected to have a salvage value of $300,000 at the end of two years and $10,000
after 4 years of use.

The section of the plant where the lemonade production would occur has been unused for
several years, and consequently had suffered some deterioration. Last year, as part of a routine
facilities improvement program, Wellness spent $80,000 to rehabilitate that section of the
main plant. The accountant, Mr Will Smith, believes this outlay, which has already been paid
and expensed for tax purposes, should be charged to the lemonade project. His contention is
that if the rehabilitation had not taken place, the firm would have to spend $80,000 to make
the site suitable for the lemonade project. Smith also informed you that a neighbouring citrus
processor had expressed an interest in leasing the lemonade production site for ten years. The
terms of the lease agreement would be a fixed rental of $24,000 per year payable in advance
and a deposit of one-year rent as bond which would be returned at the end of the lease.

The company expects to sell 250,000 cartons of the new lemonade product in each of the next
four years, at a price of $4.00 per carton, but $2.80 per carton would be needed to cover the
fixed and variable cash operating costs. In examining the sales figures, you noted a short memo

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This case study was adapted from Case 13: McReath Corporation (A) by Brigham and Gapenski (1990),
Cases in Financial Management, Orlando: The Dryden Press.

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from Wellnesss sales manager expressing concern that the fresh lemonade project would cut
into the firms sales of frozen lemonade. Specifically, the sales manager estimated that
lemonade concentrate sales would fall by 5 percent if fresh lemonade were introduced. You
then talked to both the sales and production managers, and they concluded that the new project
would probably lower the firms frozen lemonade sales by $70,000 per year, but at the same
time, it would also reduce production costs for this product by $48,000 per year, all on a pre-
tax basis.

Wellness is a private company, soundly financed and consistently profitable. Cash on hand is
not sufficient to buy the used machinery. However, Mr Harvey is confident that part of the
cost of the project could be financed with medium-term debt, privately placed with an
insurance company. Wellness had borrowed via a private placement once before when it
negotiated a fixed rate of 10 percent on a five-year loan. Preliminary discussions with
Wellnesss bankers led Mr Harvey to believe that the firm could arrange a 12 percent medium-
term loan with repayment of fixed annual interest expense in advance and the principal owing
at maturity. The companys tax rate is 30 percent, and its weighted average cost of capital is
estimated to be 14 percent.

The executive committee wants to see some type of risk analysis on the project as it might be
profitable, but what are the chances that it might turn out to be a loser. You met with the
marketing and production managers to get a feel for the uncertainties involved in the cash flow
estimates. After several sessions, they concluded that there was little uncertainty in any of the
estimates except unit sales, which could vary widely. As estimated by the marketing staff, if
product acceptance were normal, the sales quantity during Year 1 would be 250,000 cartons;
if acceptance were poor, only 200,000 cartons would be sold (the price would be kept at the
forecasted level); while if consumer response were strong, this would produce a sales volume
of 300,000 cartons for Year 1. You also discussed the scenarios probabilities with the
marketing staff. After considerable debate, they finally agreed on a guess-estimate of a 25
percent probability of poor acceptance (worst case), a 50 percent probability of average (or
most-likely case) acceptance, and 25 percent probability of excellent acceptance (best case).

After reviewing the data provided, you realised that the sales revenue and operating cost
figures have not been adjusted for inflation which is expected to average 5 percent per year
over the next 4 years. In all cases, the sales price of $4.00 is expected to increase by the 5
percent rate beginning after Year 1. On the other hand, the cash operating costs are expected
to increase by only 3 percent annually from the initial cost estimate, because over half of the
costs are fixed by long-term contracts.

You also discussed with Jason Beerman, Wellnesss director of capital budgeting, both the
risk inherent in Wellnesss average project and how the company typically adjusts for risk.
Beerman told you that, based on historical data, Wellnesss average project has a coefficient
of variation of NPV in the range of 0.8 to 1.5, and that the firm has been adding or subtracting
3 percentage points to its 14 percent overall cost of capital to adjust for differential project
risk. When you asked about the basis for the 3-percentage point adjustment, Beerman stated
that it apparently had no basis except the subjective judgement of Peter Smith, a former
director of capital budgeting who was no longer with the company. Therefore, maybe the
adjustment should be 2 percentage points, or maybe 5 percentage points or more.

If the fresh lemonade project is successfully launched, Wellness plans to extend the project
indefinitely. This means the company has to consider a replacement of the used machinery
which would not be suitable for a longer term project. You have gathered some relevant

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information for new machinery; the estimated total equipment cost is $850,000 with an
expected useful life of 8 years, at which point it could be sold for $45,000. The depreciation
rate allowed by the tax authorities is 30% on the reducing balance basis. The more efficient
new machinery would result in additional before-tax cost savings of $22,000 per year in
comparison with the used machinery.

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 ECF6110 Business Finance Report Writing Marking Guide

MARKING CRITERIA FAIL PASS CREDIT DISTINCTION HIGH DISTINCTION MARKS

AWARDED

Writing Conventions/ Repeated errors and Superficial use of Some mechanical and Evidence of superior Essentially error free. 10
Language Use: weaknesses in language. usage errors that do control of language. Varied and complex
language mechanics Sentences show little not interfere with Tone is consistent and sentences; precise,
Grammar that interfere with meaning. appropriate language,
variety. appropriate.
Spelling meaning. advanced vocabulary.
Appropriate style and
Punctuation Inconsistencies in tone, Occasional error may
Inappropriate style tone. Tone is suitable for topic
Style and tone and tone
tense and person. be apparent.
and audience.
Reasoning/ Offers simplistic, Weaker line of argument Offers solid reasoning Offers sound reasoning Substantial, logical 5
Line of argument: undeveloped, or and limited analysis. and some analysis and analysis. development of
cryptic support for Limited evidence, some Assumptions are not Contains appropriate argument and in-depth
Logical argument ideas. analysis.
and analysis irrelevant detail. always recognized or supporting evidence.
Inappropriate or off- made explicit. Argument supported by
Assumptions Assumptions not Assumptions are
topic generalizations, necessarily clear. recognised. evidence.
explained
faulty assumptions,
Supporting evidence Assumptions made
errors of fact explicit.
provided
Presentation: Untidy presentation. Some attempt at Fundamental structure Report looks neat but Correct structure, 5
Structure of report Incorrect structure. following guidelines for and format sound. may have minor including all components
structure and format but formatting problems. of report.
Format Does not follow basic Some errors in
significant errors. Structure correct.
Referencing formatting rules. consistency and layout Proper report formatting
Professionalism Problems with may appear. Referencing Correct referencing.
Inadequate or non- referencing. conventions followed
existent referencing. Referencing may Professional standard
contain some errors. but may contain minor
errors. document.

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Note: This marking guide is intended to provide a key for explicitly assessing writing skills. The content of the written report will be assessed and
allocated marks independently.