Consider the Vino project described in Exhibit T13.2. Suppose 70% of your cash flow must be retained

Question:

Consider the Vino project described in Exhibit T13.2. Suppose 70% of your cash flow must be retained in Vino until the investment is 3 years old. Blocked funds are stored with the aging wine for luck and earn no interest. Assume the that appropriately reflects the riskiness of the blocked funds is iV = 15%. The corporate income tax rate is 40%. Funds that are not blocked can be repatriated at the end of the year in which they are earned.
a. What is the of the blocked funds? What is the value of the project with these blocked funds?
b. What is the advantage of separating the value of the project into two separate parts (that is, Vproject w/ blocked funds = Vproject w/ out blocked funds + Vblocked funds)?
Exhibit T13.2
Wine production in Vino
U.K.Vino
Nominal risk-free government T-bill rateiF£ = 7.1%iFV =12.2%
Real required return on T-billsqF£ = 2.0%qFV = 2.0%
Expected future inflationp£ = 5.0%pV = 10.0%
Real required return on wine productioni£ = 12.0%iV = 12.0%
Current spot = V10/£
The following information is known about the project:
• The project has a 3-year life. Assume all operating cash flows occur at year-end.
• An investment of V800, 000 will purchase the vineyard. Its real value will remain constant throughout the investment's life and the vineyard will be sold at the end of the project.
• The winery and wine presses will cost V425, 000. In addition, the wine press supplier has given price quotes of V47, 500 and V27, 500 for the machinery's installation and modification, respectively. All cash outlays are payable at the start of the project.
• Annual depreciation for winery and wine presses is 33%, 45%, 15%, and 7% over the four-year project. (This happens to be identical to 3-year ACRS in the United States.) The winery and presses are expected to have a total market value of V45, 000 in nominal terms at the end of the project's life in three years.
• No investment in net working capital is necessary. All of the business's transactions are conducted in cash, and just-in-time inventory control will be used.
• Annual sales revenues are expected to be V700, 000, V800, 000, V900, 000 in nominal terms over the next 3 years. Variable operating costs are 10% of sales. Fixed costs are V5, 000 each year in nominal terms.
• Income and capital gains taxes are 50% in each country. Discount Rate
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