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Dan Branson, a farmer in British Columbia is exploring his entrepreneurial passion to process blueberries from his farm into blueberry jams. He has zeroed into a piece of processing equipment worth $400,000 with a five-year shelf life. Dan named the project “Merry Berry Blue” and is in talks with several retailers to sell the jams. One of the retailers assured him to take 15,000 blueberry jam jars and the number is supposed to jump by 30% annually. Initially, the retailer will pay him $12 per jar and the price will increase by 5% annually considering inflation. Similarly, Dan has the liberty to revise his price annually that usually goes up with the inflationary factor.
Dan will dispose of the machinery after five years. He wants to evaluate the project whether the same can be financially feasible. For that, he is undertaking an investment appraisal exercise with the help of a finance professional. He can guide him well on whether the said project can bring him the required profitability. Accordingly, the case study explores different case scenarios such as the given case scenario and the best and worth case scenarios also. It will help Dan and the financial analyst to reach a suitable conclusion.
Base-case NPV and IRR
The investment appraisal exercise has been conducted considering that the retailer, Choices and Whole Foods placed an order of 15,000 jars to Dan for $12 per jar. This price is supposed to increase with time owing to inflationary factors as the price rises from $12 in the 1st year to $12.60 in the 2nd year and so forth. The cash flows also show that 80% of the sales were received in the occurring year while the remaining 20% were carried to the next year as accounts receivable. Similarly, Dan at the behest of the financial advisor also negotiated for 20% of accounts payable with the suppliers that need to be paid the next year.
Notably, the variable costs constitute 20% of the sales price and it increases at a 5% rate annually. Dan hired two helps and pay them $40,000 yearly and the pay increases by 5% yearly. He also hires another employee from the 3rd year onwards and also revises his remuneration yearly. The same trend also applies to marketing costs that Dan revises periodically except for the rent which stays at $2000 monthly every year. Since the equipment will wear out by the fifth year, a depreciation of $80,000 is considered yearly to replace the equipment timely. And most importantly, the investment appraisal exercise considers a discount rate of 15% to extract the NPV.
The above table shows the investment appraisal exercise for the Merry Berry Blue case study using the base-case scenario. The result of the exercise is disappointing as it has a negative NPV. It indicates that the project will incur heavy losses in the future. The exercise also comes up with a negative IRR which points out that the cash flows the project generates are not enough to cover its initial investment (Santamaria, Paolone, Cucari, & Dezi, 2021). Thus, the base-case scenario is not feasible for Dan to consider owing to a negative NPV and IRR.
So far, as its payback and the discounted payback period are concerned, there is no such as the cash flows are not sufficient to recover the initial capital. But the profitability index of the project stands at 35%. From every front, the base-case scenario of Merry Berry Blue is not worthwhile to consider.
Best-case and Worst-case NPV and IRR
The above table shows the investment appraisal exercise using the best-case scenario. In this case, each aspect from accounts receivable to the hiring of the staff and price of the products remain the same except for the number of units sold. The best-case scenario considers that the number of jars is sold 20% above the capacity. So, the number of jars increases from 15,000 to 18,000, and so forth.
The workings show that this project also fetches a negative NPV of $73,622.97, but a positive IRR of 10%. The negative NPV can be attributed to a higher discount rate of 15%, whereas the IRR comes as 10%. It means that the project can be financially feasible if it accepts a lower discount rate that can be equivalent to 10% (Borodin, et al., 2021).
The payback period is 4.39 years indicating that the initial investment of $400,000 can be recovered within the said five years. But there is no discounted payback period which means that the discounted cash flows are not enough to recover the invested capital (Titman, Martin, Keown, & Martin, 2019). Again, the profitability index is 85% showing that the project has the potential to deliver suitable profitability. Since it has a negative NPV, it is not worth considering that a lower discount rate can alter the outcome and acceptability of the project.
This particular graph above depicts the worst-case scenario of the Merry Berry Blue case study. Considering every other thing remaining the same, only the number of units was changed. This time the number of jars was reduced by 20% to 12,000 and the numbers increased subsequently at the rate of 30% with every passing year.
So far, the worst-case scenario came up with the lowest NPV and the lowest negative IRR at 11%. It means that the cash flows were too low to recover the initial investment of $400,000. Thus, this particular project is not at all recommended.
Besides, it does not have any payback or discounted payback period as the cash flows were very low (Šimonová, Čentéš, & Beleš, 2019). The profitability index derived a negative figure of 11% indicating a loss-making project that needs to be abandoned.
Project evaluation criteria
The payback period shows how quickly the project can recover its capital costs (Titman, Martin, Keown, & Martin, 2019). Only the best-case scenario has a payback period of 4.39 years, while the others fail to recover the initial costs.
A discounted payback period shows how early the project can attain breakeven considering the discounted cash flows (Antony, 2020). The above table shows neither of the conditions is in a position to attain the break-even point.
The profitability index (PI) determines the attractiveness of the project and the higher the figure, it is considered better (Šimonová, Čentéš, & Beleš, 2019). The best-case scenario with a PI of 82% generates attractiveness among the investors followed by 35% PI of the base-case scenario. Dan should stay away from the worst-case scenario with a negative PI.
Break-even point (BEP) = Fixed costs / (Sales price per unit – Variable cost per unit)
Fixed cost = $80,000 + $24,000 + $80,000 = $184,000
Sales price per unit = $12
Variable cost per unit = $36,000 / 15,000 = $2.40
BEP = $184,000 / ($12 – $2.40)
= $184,000 / $9.60 = 19,166.67 units
The break-even point stands at 19,167 units approximately. This is the desired unit for Dan to attain a break-even point. So, producing just 15,000 jars of jam will not be enough for him to get the desired profitability.
Degree of operating leverage = (Sales – Variable cost) / (Sales – Variable cost – Fixed cost)
= ($180,000 – $36,000) / ($180,000 – $36,000 – $184,000)
= $144,000 / -$40,000 = -0.09 or -9%
The degree of operating leverage determines how the operating income gets affected as the sales proportion changes (Borodin, et al., 2021). In this case, the value is negative indicating that the cash flows are not sufficient enough to cover the costs.
- Dan should opt for neither of the projects as NPV in all the cases is negative.
- The production needs to be increased to attain the break-even point and eventually, profitability.
- The discount rate of the project should be reviewed to have a lower hurdle rate.
Antony, A. (2020). Behavioral finance and portfolio management: Review of theory and literature. Journal of Public Affairs, 20(2), e1996.
Borodin, A., Mityushina, I., Streltsova, E., Kulikov, A., Yakovenko, I., & Namitulina, A. (2021). Mathematical modeling for financial analysis of an enterprise: Motivating of not open innovation. Journal of Open Innovation: Technology, Market, and Complexity, 7(1), 79.
Santamaria, R., Paolone, F., Cucari, N., & Dezi, L. (2021). Non‐financial strategy disclosure and environmental, social and governance score: Insight from a configurational approach. Business Strategy and the Environment, 30(4), 1993-2007.
Šimonová, J., Čentéš, J., & Beleš, A. (2019). Financial analysis of innovative forms of money. Entrepreneurship and Sustainability Issues, 7(1), 69.
Titman, S., Martin, T., Keown, A., & Martin, J. (2019). Financial Management: Principles and Applications (8th ed.). Melbourne: Pearson.