Suppose Bell Craft Beer is considering which of two fermentation systems to purchase. The Simon model will

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Question:

Suppose Bell Craft Beer is considering which of two fermentation systems to purchase. The Simon model will cost $150,000, will have expenses (excluding depreciation) of $500,000 per year, and will have a useful life of three years. The Pearce model will cost $200,000, will have expenses (excluding depreciation) of $480,000 per year and will have a useful life of four years. Cash receipts generated from beer sales will be the same for both systems and are estimated at $1,000,000 per year. Bell depreciates its equipment down to a $0 value at the end of the estimated useful life using the straight-line method. Actual salvage values are expected to be $30,000 for the Simon model and $24,000 for the Pearce model. The weighted average cost of capital for Bell is 12%, however, the purchase of equipment is considered to be less risky than the firm’s average projects and thus requires an 11% rate of return. Bell’s tax rate is 30%.

a. Which fermentation system should Bell purchase? In coming to your decision, clearly identify the following: (26 points)

Initial outlays
Operating cash flows
Terminal cash flows
Capital budgeting method used and why you chose it over the alternatives
Adjustments needed to handle any complications in the analysis

b. Suppose Bell wanted to adjust for risk using the Certainty Equivalent method and they estimate α = .90. Describe in words how they would use α in their calculations and what other adjustments in the calculation and/or the decision rule would be needed. You do not need to actually calculate anything.

c. Assume the supply and quality of hops (the main ingredient in beer) may rise or fall from the base case assumption and therefore the operating expenses for both systems may fluctuate up or down as well. Additionally, revenues may rise or fall compared to the base case assumption of $1,000,000 depending on the taste profile of the beers due to the quality of hops. Explain how could you build that information into your analysis. Again, you do not need to calculate anything; describe it in words only.

d. Would Bell be likely to do a simulation analysis for this capital budgeting analysis? Explain why or why not.