# Question: After graduating from business school George Clark went to work

After graduating from business school, George Clark went to work for a Big Six accounting firm in San Francisco. Because his hobby has always been wine making, when he had the opportunity a few years later he purchased five acres plus an option to buy 35 additional acres of land in Sonoma Valley in Northern California. He plans eventually to grow grapes on that land and make wine with them.

George knows that this is a big undertaking and that it will require more capital than he has at the present. However, he figures that if he persists, he will be able to leave accounting and live full time from his winery earnings by the time he is 40. Because wine making is capital-intensive and because growing commercial-quality grapes with a full yield of five tons per acre takes at least eight years, George is planning to start small. This is necessitated by both his lack of capital and his inexperience in wine making on a large scale, although he has long made wine at home. His plan is first to plant the grapes on his land to get the vines started. Then he needs to set up a small trailer where he can live on weekends while he installs the irrigation system and does the required work to the vines, such as pruning and fertilizing.

To help maintain a positive cash flow during the first few years, he also plans to buy grapes from other nearby growers so he can make his own label wine. He proposes to market it through a small tasting room that he will build on his land and keep open on weekends during the spring–summer season.

To begin, George is going to use $10,000 in savings to finance the initial purchase of grapes from which he will make his first batch of wine. He is also thinking about going to the Bank of Sonoma and asking for a loan. He knows that if he goes to the bank, the loan officer will ask for a business plan; so he is trying to pull together some numbers for himself first. This way he will have a rough notion of the profitability and cash flows associated with his ideas before he develops a formal plan with a pro forma income statement and balance sheet. He has decided to make the preliminary planning horizon two years and would like to estimate the profit over that period. His most immediate task is to decide how much of the $10,000 should be allocated to purchasing grapes for the first year and how much to purchasing grapes for the second year. In addition, each year he must decide how much he should allocate to purchasing grapes to make his favorite Petite Sirah and how much to purchasing grapes to make the more popular Sauvignon Blanc that seems to have been capturing the attention of a wider market during the last few years in California.

In the first year, each bottle of Petite Sirah requires $0.80 worth of grapes and each bottle of Sauvignon Blanc uses $0.70 worth of grapes. For the second year, the costs of the grapes per bottle are $0.75 and $0.85, respectively.

George anticipates that his Petite Sirah will sell for $8.00 a bottle in the first year and for $8.25 in the second year, while his Sauvignon Blanc’s price remains the same in both years at $7.00 a bottle. Besides the decisions about the amounts of grapes purchased in the two years, George must make estimates of the sales levels for the two wines during the two years. The local wine-making association has told him that marketing is the key to success in any wine business; generally, demand is directly proportional to the amount of effort spent on marketing. Thus, since George cannot afford to do any market research about sales levels due to his lack of capital, he is pondering how much money he should spend to promote each wine each year.

The wine-making association has given him a rule of thumb that relates estimated demand to the amount of money spent on advertising. For instance, they estimate that for each dollar spent in the first year promoting the Petite Sirah, a demand for five bottles will be created; and for each dollar spent in the second year, a demand for six bottles will result. Similarly, for each dollar spent on advertising for the Sauvignon Blanc in the first year, up to eight bottles can be sold; and for each dollar spent in the second year, up to ten bottles can be sold. The initial funds for the advertising will come from the $10,000 savings. Assume that the cash earned from wine sales in the first year is available in the second year.

A personal concern George has is that he maintain a proper balance of wine products so that he will be well positioned to expand his marketing capabilities when he moves to the winery and makes it his full-time job. Thus, in his mind it is important to ensure that the number of bottles of Petite Sirah sold each year falls in the range between 40% and 70% of the overall number of bottles sold.

Questions

1. George needs help to decide how many grapes to buy, how much money to spend on advertising, how many bottles of wine to sell, and how much profit he can expect to earn over the two-year period. Develop a spreadsheet LP model to help him.

2. Solve the linear programming model formulated in Question 1.

3. After showing the business plan to the Bank of Sonoma, George learns that the loan officer is concerned about the market prices used in estimating the profits—recently it has been forecasted that Chile and Australia will be flooding the market with high-quality, low-priced white wines over the next couple of years. In particular, the loan officer estimates that the price used for the Sauvignon Blanc in the second year is highly speculative and realistically might be only half the price George calculated. Thus, the bank is nervous about lending the money because of the big effect such a decrease in price might have on estimated profits. What do you think?

4. Another comment the loan officer of the Bank of Sonoma has after reviewing the business plan is:“I see that you do have an allowance in your calculations for the carryover of inventory of unsold wine from the first year to the second year, but you do not have any cost associated with this. All companies must charge something for holding inventory, so you should redo your plans to allow for this.” If the holding charges are $0.10 per bottle per year, how much, if any, does George’s plan change?

5. The president of the local grape growers’ association mentions to George that there is likely to be a strike soon over the unionization of the grape workers. (Currently they are not represented by any union.) This means that the costs of the grapes might go up by anywhere from 50% to 100%. How might this affect George’s plan?

6. Before taking his business plan to the bank, George had it reviewed by a colleague at the accounting firm where he works. Although his friend was excited about the plan and its prospects, he was dismayed to learn that George had not used present value in determining his profit.“George, you are an accountant and must know that money has a time value; and although you are only doing a two-year planning problem, it still is important to calculate the present value profit.” George replies, “Yes, I know all about present value. For big investments over long time periods, it is important to consider. But in this case, for a small investment and only a two-year time period, it really doesn’t matter.”

Who is correct, George or his colleague? Why? Use an 8% discount factor in answering this question. Does the answer change if a 6% or 10% discount rate is used? Use a spreadsheet to determine the coefficients of the objective function for the different discount rates.

7. Suppose that the Bank of Sonoma is so excited about the prospects of George’s wine-growing business that they offer to lend him an extra $10,000 at their best small business rate—28% plus a 10% compensating balance. Should he accept the bank’s offer? Why or why not?

8. Suppose that the rule of thumb George was given by the local wine-making association is incorrect. Assume that the number of bottles of Petite Sirah sold in the first and second years is at most four for each dollar spent on advertising. And likewise for the Sauvignon Blanc, assume that it can be at most only five in years 1 and 2.

9. How much could profits be increased if George’s personal concerns are ignored?

George knows that this is a big undertaking and that it will require more capital than he has at the present. However, he figures that if he persists, he will be able to leave accounting and live full time from his winery earnings by the time he is 40. Because wine making is capital-intensive and because growing commercial-quality grapes with a full yield of five tons per acre takes at least eight years, George is planning to start small. This is necessitated by both his lack of capital and his inexperience in wine making on a large scale, although he has long made wine at home. His plan is first to plant the grapes on his land to get the vines started. Then he needs to set up a small trailer where he can live on weekends while he installs the irrigation system and does the required work to the vines, such as pruning and fertilizing.

To help maintain a positive cash flow during the first few years, he also plans to buy grapes from other nearby growers so he can make his own label wine. He proposes to market it through a small tasting room that he will build on his land and keep open on weekends during the spring–summer season.

To begin, George is going to use $10,000 in savings to finance the initial purchase of grapes from which he will make his first batch of wine. He is also thinking about going to the Bank of Sonoma and asking for a loan. He knows that if he goes to the bank, the loan officer will ask for a business plan; so he is trying to pull together some numbers for himself first. This way he will have a rough notion of the profitability and cash flows associated with his ideas before he develops a formal plan with a pro forma income statement and balance sheet. He has decided to make the preliminary planning horizon two years and would like to estimate the profit over that period. His most immediate task is to decide how much of the $10,000 should be allocated to purchasing grapes for the first year and how much to purchasing grapes for the second year. In addition, each year he must decide how much he should allocate to purchasing grapes to make his favorite Petite Sirah and how much to purchasing grapes to make the more popular Sauvignon Blanc that seems to have been capturing the attention of a wider market during the last few years in California.

In the first year, each bottle of Petite Sirah requires $0.80 worth of grapes and each bottle of Sauvignon Blanc uses $0.70 worth of grapes. For the second year, the costs of the grapes per bottle are $0.75 and $0.85, respectively.

George anticipates that his Petite Sirah will sell for $8.00 a bottle in the first year and for $8.25 in the second year, while his Sauvignon Blanc’s price remains the same in both years at $7.00 a bottle. Besides the decisions about the amounts of grapes purchased in the two years, George must make estimates of the sales levels for the two wines during the two years. The local wine-making association has told him that marketing is the key to success in any wine business; generally, demand is directly proportional to the amount of effort spent on marketing. Thus, since George cannot afford to do any market research about sales levels due to his lack of capital, he is pondering how much money he should spend to promote each wine each year.

The wine-making association has given him a rule of thumb that relates estimated demand to the amount of money spent on advertising. For instance, they estimate that for each dollar spent in the first year promoting the Petite Sirah, a demand for five bottles will be created; and for each dollar spent in the second year, a demand for six bottles will result. Similarly, for each dollar spent on advertising for the Sauvignon Blanc in the first year, up to eight bottles can be sold; and for each dollar spent in the second year, up to ten bottles can be sold. The initial funds for the advertising will come from the $10,000 savings. Assume that the cash earned from wine sales in the first year is available in the second year.

A personal concern George has is that he maintain a proper balance of wine products so that he will be well positioned to expand his marketing capabilities when he moves to the winery and makes it his full-time job. Thus, in his mind it is important to ensure that the number of bottles of Petite Sirah sold each year falls in the range between 40% and 70% of the overall number of bottles sold.

Questions

1. George needs help to decide how many grapes to buy, how much money to spend on advertising, how many bottles of wine to sell, and how much profit he can expect to earn over the two-year period. Develop a spreadsheet LP model to help him.

2. Solve the linear programming model formulated in Question 1.

3. After showing the business plan to the Bank of Sonoma, George learns that the loan officer is concerned about the market prices used in estimating the profits—recently it has been forecasted that Chile and Australia will be flooding the market with high-quality, low-priced white wines over the next couple of years. In particular, the loan officer estimates that the price used for the Sauvignon Blanc in the second year is highly speculative and realistically might be only half the price George calculated. Thus, the bank is nervous about lending the money because of the big effect such a decrease in price might have on estimated profits. What do you think?

4. Another comment the loan officer of the Bank of Sonoma has after reviewing the business plan is:“I see that you do have an allowance in your calculations for the carryover of inventory of unsold wine from the first year to the second year, but you do not have any cost associated with this. All companies must charge something for holding inventory, so you should redo your plans to allow for this.” If the holding charges are $0.10 per bottle per year, how much, if any, does George’s plan change?

5. The president of the local grape growers’ association mentions to George that there is likely to be a strike soon over the unionization of the grape workers. (Currently they are not represented by any union.) This means that the costs of the grapes might go up by anywhere from 50% to 100%. How might this affect George’s plan?

6. Before taking his business plan to the bank, George had it reviewed by a colleague at the accounting firm where he works. Although his friend was excited about the plan and its prospects, he was dismayed to learn that George had not used present value in determining his profit.“George, you are an accountant and must know that money has a time value; and although you are only doing a two-year planning problem, it still is important to calculate the present value profit.” George replies, “Yes, I know all about present value. For big investments over long time periods, it is important to consider. But in this case, for a small investment and only a two-year time period, it really doesn’t matter.”

Who is correct, George or his colleague? Why? Use an 8% discount factor in answering this question. Does the answer change if a 6% or 10% discount rate is used? Use a spreadsheet to determine the coefficients of the objective function for the different discount rates.

7. Suppose that the Bank of Sonoma is so excited about the prospects of George’s wine-growing business that they offer to lend him an extra $10,000 at their best small business rate—28% plus a 10% compensating balance. Should he accept the bank’s offer? Why or why not?

8. Suppose that the rule of thumb George was given by the local wine-making association is incorrect. Assume that the number of bottles of Petite Sirah sold in the first and second years is at most four for each dollar spent on advertising. And likewise for the Sauvignon Blanc, assume that it can be at most only five in years 1 and 2.

9. How much could profits be increased if George’s personal concerns are ignored?

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