• April 24th, 2016

Financial Management Donaldson’s Dairy

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Donaldson’s Dairy

Hairy Maclary inherited his dairy farm from his father about ten years ago. His

father had in turn inherited the farm from his father. The farm currently has 125

milking cows in the farm located in Casino, NSW. In order to be able to run this

many cows and ensure they are milked in a timely manner the farm employs two

farm hands on a part-time basis. These employees work 25 hours a week and

are paid $20 an hour. They each work 48 weeks a year and receive

superannuation at a rate of 9.5% of their gross pay.

In order to make his life a little easier on the farm, Maclary has decided to

purchase an automatic rotor milking machine. The milking machine with the most

potential is the Rotor 700. To facilitate this purchase, Maclary has employed the

services of Schnitzel von Krumm to analyse the viability of such an investment.

Von Krumm’s report is $50,000. $30,000 was paid before the report was

prepared and a further $20,000 was to be paid if the decision was made to

undertake the project. Other costs incurred by Mr Krumm include the cost of

flights from Sydney to London and appropriate accommodation. He will fly first

class and these flights will amount to $10,000. Economy class fares are $3,000.

Accommodation, meals and incidentals will cost $3,000. These costs will be

incurred before the decision is made.

Mr Maclary’s tax advisor is Mr Hercules Morse CPA. He has advised that the

entire cost of Krumm’s report is 100% tax deductible while 75% of the flights are

tax deductible and the other costs associated with the report are 50% deductible.

The new machine will cost $500,000 and can be depreciated straight line over 10

years for tax purposes. Accounting depreciation is 15% reducing balance. Mr

Morse has recommended that the 15% reducing balance depreciation rate be

used for any analysis.

Details of the project are as follows:

• Mr Maclary will also need to build a new shed to house the milking

machine. This will cost $100,000 and can be depreciated for tax and

accounting purposes over 5 years straight line.

• The area where the shed will be built previously housed a machinery

parking lot. Currently this is leased to the next-door neighbour for $1000

per month but Maclary had renegotiated this with him and the neighbour

was prepared to pay $1500 per month from now on.

• Delivery and installation costs will be $100,000. Mr Morse believes that

these should be expensed although the ATO has advised this need to be

3(5)

included in the value of the machinery for depreciation purposes. Mr Morse

is adamant that these must be expensed and a 50% tax deduction is

available.

• Mr Bitzer Maloney will provide management of the new facility. He will be

paid $75,000 per annum (inclusive of superannuation) and this will increase

by 10% per annum. The two farm hands will no longer be needed and will

be paid a redundancy of $10,000 each (with no superannuation payable)

when the new machine is purchased. These redundancy payments are tax

deductible immediately.

• The new machine will be able to be sold for $50,000 at the end of the

projects life in year 10. The shed will be worthless at the end of the project.

• The advantage of the new machine is that the farm will be able to increase

the number of cows from 125 to 250. It also means that the farm will be

able to increase milk production from 1 million to 1.5 million litres. In year

one, milk will sell for $1 per litre and increase by 10% per year from year 2

onwards. The farm will also be able to produce 200,000 litres of cream.

This will sell for $2 per litre and is expected to increase by 5% per annum

from year 2 onwards. In year 5, the number of cows will increase to 300.

This will result in a 20% increase in output.

• Sales of beef will, however, fall by $250,000 per year. Meat prices were

expected to increase by 6% per year from year 2 onwards. This means that

lost sales were also expected to increase by 6% per annum.

• Mr Maclary will run tours of the new facility and these are expected to

generate revenues of $100,000 per annum.

• The project is expected to need an increase in working capital from

$100,000 to $200,000 initially.

• Costs of production (farm costs) are 30% of net sales of milk, cream and

beef.

• Tools currently used in another part of the farm will be used with the new

machine. These used tools have a market value of $10,000 but will need to

be replaced with new tools. These are expected to cost $20,000. These

are currently depreciated for tax purposes over 2 years and will have no

salvage value.

The farm maintains a photo library at its office in the main street of Casino. The

farm devotes one floor of its office to this library, which contains copies of some

4(5)

of the most beautiful photos taken in Casino over the last 50 years. The rent is

currently $10,000 per year.

The farm plans to borrow 100% of the funds required to purchase the new

machine from Westpac. Interest rates are expected to be 8% per annum fixed for

the life of the loan. All interest payments are tax deductible. The loan will be an

interest only 10-year loan with the full amount repaid in year 10.

The farm maintains a constant debt-to-equity ratio of 60%. The cost of debt for

the farm is 8% per annum. The real rate of return of the ASX200 index is 10% pa

and the real rate of return on government bonds is 3% pa. The beta of the farm is

1.5. Projects such as this typically require an additional 2.5% premium on top of

the firm’s WACC.

Note:

• The current rate of inflation is 3.0% p.a. Maclary pays tax at 30 cents in the

dollar.

• All tax benefits are received in the year in which the expenditure is incurred

unless otherwise stated.

• All amounts and interest rates are in real dollars and percentages.

• All analysis should be undertaken in real dollars.

Required:

The assessment must be produced on the Spreadsheet found in the

assignment tab on iLearn.

You will be assessed on the following criteria:

(a) Calculate the cash flows at the start of the investment (t=0). (2 Marks)

(b) Calculate the cash flows over the life of the investment (t=1,2,3…9). (2

Marks)

(c) Calculate the cash flows at the end of the investment (t=10). (2 Marks)

(d) What is the appropriate discount rate for the project? (2 Marks)

(e) What is the Net Present Value of the Project? (2 Marks)

5(5)

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