You are advising Loch Lochy Liquors Limited (LLL), manufacturer of a premium Scotch whisky selling under the brand name "Highland Princess". You have been summoned to a meeting of LLL's management team, in the chamber of the company's Chairman, Hamish Macbeth. The others present at the meeting are Managing Director Sally Grogan, Factory Manager Kofi Nyarko, Marketing Manager Saleem Rushdie, Accounts Manager Rick Corder, and Manager (Research & Development) Peipei Wong. You have been asked to prepare a financial appraisal in respect of LLL's capital expenditure programme.

Start of meeting

Hamish: Okay, let's get this meeting started. As we all know, due to various constraints our capital expenditure budget for this year cannot exceed 4 million under any circumstances. What are the proposals we're looking at?

Sally: Well Saleem, as you know, wants to use the money for developing and expanding our Scotch whisky market in areas like South Asia and the Far East. But we also have an alternative proposal from Peipei for development of a cheaper variety of whisky made from rye, using available space in our existing distillery building.

Discussion on revenue estimates

Hamish: If we go for the rye whisky venture, what is the selling price you expect to fix for the new product? Saleem: 9.50 per bottle of rye whisky is what we've agreed with the distributors.

Sally: And what kind of output are we looking at?

Saleem: I estimate a demand of 500,000 bottles of rye whisky in the first year, increasing at a uniform growth rate of 8% every year for the duration of the project.

Hamish: Will we have any difficulty meeting that level of demand?

Kofi: That will not be a problem; it's well within the proposed capacity. Loch Lochy Liquors Limited

Discussion on cost estimates

Hamish: Wherever the rye whisky project is located, there will be rental costs - we need to know just how much of space would be required for the rye whisky project, Peipei?

Peipei: Well, we only need to locate it in the unused section at the eastern end of the building. There's 50,000 sq. ft. of space available there, which is more than enough. Hamish: Hold on - weren't we planning to lease out that section for 30,000 a year?

Kofi: Yes, but that proposal would be dropped if we go in for diversification. It'll save us the cost of building a new shed.

Sally: The new product would have to bear a fair share of the building rent, though. How much would that work out to, Rick?

Rick: (Doing a quick computation on his calculator) Let's see - we're paying 135,000 a year for the whole area of 150,000 sq. ft.; that means the rent chargeable to the new product would be 45,000 per year.

Sally: (Nodding in your direction) I'm sure you won't forget to take that into account in your appraisal.

Kofi: (Addressing you) We'd also have to spend about 200,000 on renovating and rebuilding that section for the new project perhaps we ought to include that cost too?

Hamish: Apart from the premises, exactly how much is the project going to cost, Peipei?

Peipei: I've worked out that the equipment for the rye whisky project would cost 3.3 million, plus an additional 100,000 for shipping and installation.

Hamish: Will all that equipment be worth anything at the end?

Peipei: For investment appraisal purposes it is safe to estimate the useful life of the project is five years. We reckon that the rye whisky equipment would have a salvage value of 400,000 (at today's prices).

Sally: What about working capital investment? We will have to offer at least our standard credit terms to buyers of the new product.

Kofi: Yes, and we have also made a detailed estimate of the inventory levels required to meet the production targets.

Rick: Assuming no change in our suppliers' credit terms, we have estimated that, for the rye whisky project the level of net working capital investment required to be in place at the start of each year should be equal to roughly 9% of that years estimated rye whisky sales.

Hamish: Is that all? I'd have thought it would be more wont there be an increase in the level of debtors as we make our push in the rye whisky market?

Saleem: (interjecting) Yes there will, but it will be a net increase, after allowing for the reduction in debtors on account of our Scotch whisky, Highland Princess. That's one aspect of the rye whisky project that worries me a lot - it's going to take away sales from Highland Princess, on which we presently earn a contribution of 8 a bottle.

Sally: How much do you estimate Highland Princess's sales would come down by?

Saleem: Given the output targets for the rye whisky, I would reckon that Highland Princess sales would be reduced by about 90,000 bottles per annum.

Sally: Well that's a problem which you'd have to try and address by intensifying your marketing effort for Highland Princess Saleem. It doesn't really have anything to do with the financial appraisal of the rye whisky project, does it?

Saleem: (a trifle doubtfully) Welll, I guess not.

Hamish: Have you assessed the operating costs of the new project?

Kofi: Yes; our estimate is that cash operating cost - that is, operating cost before charging depreciation - would amount to about 45% of selling price for the rye whisky project.

Hamish: Does that include all costs?

Rick: No, those are just the variable factory costs there are other costs to include. I've already mentioned the apportionment of rent. In addition, we'd apportion a part of our existing administrative costs, to the tune of 90,000 per annum. There would also be extra sales promotion expenses of 150,000 a year, and interest charges of 350,000 a year on the loan needed to finance the project.

Hamish: Isnt depreciation a cost that should be taken account?

Rick: Yes of course, depreciation would have to be charged over the life of the project, using our usual straight line method.

Hamish: What about the tax angle?

Rick: Well, our company's tax rate is 19%, but we're entitled to capital allowances at 18% on the written down value of the new equipment.

Discussion on other factors

Rick: All the revenue and cost estimates we have discussed so far are at today's prices. But the rate of inflation is 3% per annum. Will that be relevant in any way?

Sally: It isn't necessary to bother about inflation. I know that all the cash flow estimates are at today's prices, but inflation is going to affect both sides - revenues as well as costs. The net effect on the project will be negligible.

Hamish: (Thoughtfully) Im not sure you're right but well leave that to our financial consultant to decide.

Hamish: (Turning towards you) I hope you've taken note of all that information. What I want is a financial appraisal of the merits of the project based on this information, all of which has been carefully compiled by my staff and can be assumed to be approximately correct. I don't suppose that the proposed project would be any more or less risky than our present operations, so you can use our existing cost of capital for your computations. How much is that at present, Rick?

Rick: We don't have an up-to-date estimate - I expected that would be left to the financial consultant. I suppose youre right about the risk being the same - whichever project (or projects) we undertake, we are aiming to maintain our current gearing level of 59% (by that I mean a debt to equity ratio of 0.59:1). I think that will be quite acceptable to our shareholders and lenders.

Hamish: Oh yes, the market seems quite happy with the way we have steadily increased our dividend to the present level of 45 pence per share more than twice the amount of 21 pence per share when we first started paying dividends eight years ago. Our dividend has grown at a steady rate, and our high share price of 707 pence reflects that.

Sally: I don't see the relevance of a detailed cost of capital computation. The main source of finance for the project is going to be a term loan from our bankers at our current borrowing rate of 11% per annum. Surely this interest rate of 11% on the finance raised for the current project should be the appropriate cost of capital for the project evaluation?

Peipei: Why should it be even that? I don't understand why loan finance is necessary at all when we can just make use of retained profits, which are absolutely free.

Hamish: I think the question of determining the appropriate cost of capital is something we can safely leave to our financial consultants.

Discussion on alternative project

Hamish: I am concerned that the rye whisky project would eat up almost the entire available capital of 4 million, leaving us nothing to spend on developing our existing line.

Saleem: (Enthusiastically) Yes, that is the problem! My alternative proposal for investing the 4 million for additional production of Highland Princess for the South Asian and Far Eastern market will generate large net cash flows of 3 million in each of the first two years, after providing for all relevant expenses, inflation, capital allowances and taxation. As competition in those markets is expected to increase, the net cash flows would fall off to 1 million per year in the third and fourth years, and to just 0.25 million by year 5 - but this market expansion project still has a high IRR of close to 50% and a quick payback period. This represents better value for the shareholders than the rye whisky project.

Hamish: Is it possible to reduce the size of the rye whisky project?

Peipei: No; all our estimates are based on the MINIMUM workable size of the project - it is not possible to partially implement the new project.

Saleem: The same goes for the expansion project in Asia and the Far East - it has to be implemented fully or not at all. 5 Conclusion of meeting Hamish: (Nodding towards you) I hope you'll make a note of Saleem's points, and let me have your analysis soon. Your report should indicate which course of action is preferable, with clear explanations wherever necessary. Please make sure that you take account of all the information you gathered here today. If you omit any of it, I'll want to know why we do need your professional advice and constructive comments on any errors of reasoning or technical weaknesses that you may have observed in the various arguments and suggestions made during the course of this meeting. Thank you.

Required:

1. Using the information provided in pages 1 to 3 of the case, estimate the annual incremental cash flows of the proposed rye whisky project, providing explanations of your reasons for including or excluding any of the information that has been provided. (circa 30 marks)

2. Reading the information provided on page 4 (conversation in italic and bold), discuss the views expressed by the Managing Director (Sally) and the R&D Manager (Peipei) about the appropriate cost of capital to use for evaluating these projects, and suggest what the appropriate cost of capital should be. Please provide full explanations of the points that you make in your discussion, using your own words. (circa 12 marks)

3. Based on your cash flow estimation of the rye whisky project, and using the cash flows that have been provided in respect of the alternative project for expanding the companys existing operations into the South Asian and Far Eastern markets, perform a comparative evaluation of the two projects. [Note: The net nominal after-tax cash flows of market expansion to South Asia and Far East are already provided in the case (by the Marketing Manager, Saleem) so no further cash flow estimation is required in respect of the expansion project]. Use whatever project appraisal techniques you consider to be useful and relevant to the problem. (circa 13 marks)

4. Explain why the IRR technique of investment appraisal may sometimes cause adverse project selection decisions when choosing between two mutually exclusive projects, even though each project requires roughly the same level of initial investment. Discuss how this problem could be overcome. (circa 8 marks)

5. Based on your chosen investment appraisal method(s) recommend an appropriate course of action for Loch Lochy Liquors. Also comment on other aspects that the management team may wish to consider in respect of either of these investments (not just the one that you are recommending). (circa 12 marks)