In December 2022, Husam Ali, the owner of Jaffa Beverage Company (JBC), had just completed reading a
Question:
In December 2022, Husam Ali, the owner of Jaffa Beverage Company (JBC), had just completed reading a report prepared by Zaid Ahmed, his general manager, regarding the potential investment in a new product line named Dream-Kola. Months prior, when Ali attended a youth obesity workshop on a high school of his two children, he had the idea for Dream-Kola. After the workshop, Husam and Zaid Ahmed talked about the idea of Dream-Kola, a cheap, calorie-free carbonated soft drink. Given that the business hadn't launched a new product in the last few years, Ahmed enjoyed the opportunity to introduce something new.
Company Background
Jaffa Beverage Company, based in Ramallah, Palestine, is a small, privately owned carbonated soft drink company. Salam Ali, a retired executive from a major fast-food restaurant chain, launched JBC in 2008. Due to the high obesity rate in Palestine, health and consumer lobby’s requested that the government apply a 20% tax on soft drinks, stating that not only would it lower consumption, but the tax revenue could also be utilized to fight the medical problems caused by soft drinks.
The market leadersfor carbonated soft drinksin Palestine were Coca-Cola and Pepsi-Cola. Together, they accounted for a combined market share of more than 90%, with Coca Cola being the major player. Salam believed that the prices charged by these big international corporations were out of reach for the poorer families of society. To enter this market, he founded the company to sell private-labeled carbonated soft drinks with identical flavors but at a half of the price. His products included standard cola carbonates as well as non-cola carbonates like lemon/lime or orange carbonates.
In Palestine, Jaffa Beverage Company products were only available in small local grocery stores. Because it couldn't keep the required margin in these large outlets, JBC avoided supermarkets and hypermarkets. Furthermore, most consumers, particularly those with middle-to-low incomes, buy from small food stores. Owners of these small shops were given incentives to personally market and promote the products. Sales have increased significantly from $8 million in 2008 to around $90 million in 2021.
When Salam died unexpectedly in 2017, his only son, Husam Ali, took over the firm. Husam began working in sales two years before his father's death. He had learned a few excellent business ideas from his father, which had turned him into a very conservative business man. As consumers became more price aware and switched from international names to private labels, demand increased. Jaffa Beverage Company's sales increased by 60% between 2018 and 2019, yet the company's business strategy and practices remained unchanged. In latest years, the company's return on sales (net profit margin) has also increased.
The Proposal
Husam read the executive summary of the report and thought of the advice his father had provided him repeatedly over the two years he had been working with him: "Don't expand the business just for the sake of expanding. A new product should only be developed if you are certain there is enough demand for it and you have the resources to do so. Husam believed the time was ideal in terms of financial resources. Jaffa Beverage Company has accumulated a considerable amount of cash as a result of its recent success in terms of sales and profitability. His banker had agreed to give him a five-year term loan to launch Dream-Kola at a rate of 16% annual interest due to his strong financial performance and consistent cash flows. According to Zaid Ahmed's estimations in the proposal, the project's weighted average cost of capital would be 18.2% with a 20/80 debt-to-equity structure if 20% of the required capital was borrowed. Husam was more concerned with whether there would be adequate demand for this new, calorie-free product line. Even though the demand for low-calorie sodas has grown in Palestine, it was thought that they were mostly consumed by people in the middle-to-upper class.
Most people with lower incomes continued to solely drink regular, highly sweetened carbonated soft beverages. It was unclear whether this was due to the low-income group's ignorance about the obesity problem or the lack of inexpensive, calorie-free beverage options. If the former were true, the future for inexpensive, calorie-free carbonated soft drinks might not be all that promising right now. If the latter were the case, the launch of Dream-Kola by Jaffa Beverage Company may be ideal.
Following Husam's discussion of the Dream-Kola proposal with him, Ahmed immediately contracted a consultant to conduct a market research. The expert predicted that the business might sell 200,000 liters of these zero-calorie carbonates in a given month at an anticipated selling price of $1 a liter. At the same price, this sales volume was anticipated for a five-year period. The market study took almost two months to complete and cost the business $5 million, which Ahmed had already paid.
Because the existing bottling facility was manufacturing normal sodas at 100% capacity, the proposal called for a fleet of new, semi-automated bottling and kegging machines designed for long, high-quality runs. These machines were anticipated to cost $5 million in total, including installation. This value might be fully depreciated on a straight-line basis during a five-year period. Ahmed anticipated that by purchasing these machines, Jaffa Beverage Company would be able to cut its labor costs and hence the price to customers, putting the company in a more competitive position. These machines, with proper maintenance, could produce at least 200,000 liters of carbonated drinks every month. Ahmed further calculated that if the corporation stopped down Dream-Kola production or replaced these machines with fully automated ones in five years, these machines would have a resale value of $400,000.
Ahmed also predicted that these machines will be resalable. The new machines would be housed in a vacant annex by Jaffa Beverage Company's main production site. The annex was also large enough to keep finished goods before shipping them to grocery stores. Husam's father built the annex years ago as part of his ambition to enter the mineral water business. He died before he could bring his plan into practice. Husam had recently received an offer to lease the annex for $6,000 per year, but it had remained vacant since. Ahmed assessed that additional working capital was required to enable the smooth manufacture and sales of this new product line. He proposed retaining raw material inventory at one month's worth of production. To encourage independent grocery stores to carry the new product line, he offered a longer collection period, allowing grocers to pay in 45 days rather than the standard 30 days. In terms of accounts payable, he would adhere to the company's standard procedure and settle the debts within 36 days.
The plan included estimates for production and overhead expenditures, as well as selling charges. The raw components required to make the sodas were expected to cost $0.08 a liter, with monthly labor and energy costs of $8,000 and $5,000, respectively. Because the new product could be distributed by Jaffa Beverage Company's existing sales staff and distribution networks, the incremental general administration and selling expenses were fairly low, estimated at $100,000 per year. For any new projects, the accounting department charged 1% of sales as overhead costs. Husam began to think while refocusing on his notes. According to the market research, there appears to be considerable demand for the new product line. What he truly feared was that the new zerocalorie carbonates would reduce sales of his old products, which were normal sodas. According to the market research, potential erosion might cost the company up to $80,000 in after-tax cash flows every year. Could he add value to the corporation by taking on this project at the new 30% tax rate on both income and capital gain?
Assignment Questions
1. Which cash flows are relevant? How should we treat the following costs when analyzing the capital budgeting for this low-cost, low-calorie beverage project?
a. Cost of the consultant's market analysis.
b. The vacant annex's possible rental value.
c. the interest fees.
d. Working capital.
2. Should the analysis take into account the erosion of the current product (the ordinary sodas)? Why or why not.
3. Calculate the NPV, IRR, payback period, discounted payback, and profitability index for the project
4. Conduct sensitivity analysis on the volume of sales, price, cost of direct labor, cost of materials, and cost of energy. What do you observe? (Hint: Prepare two additional Scenarios in excel to recalculate NPV, payback period, discounted payback period, and profitability index):
Scenario 2: Increase in Direct Labor Costs by 5% and Increase in Energy Costs by 5%
Scenario 3: Decrease in Sales Volume by 2%, Increase in Sales Price by 5%, Increase in Raw Material Costs by 5%, Increase in Direct Labor Costs by 5%, and Increase in Energy Costs by 5%
5. What are the benefits and risks of undertaking this project?
6. Should JBC undertake this project?
Managerial Accounting
ISBN: 978-1259307416
16th edition
Authors: Ray Garrison, Eric Noreen, Peter Brewer