MOUNTAIN BLEND SPECIALITY COFFEE CO
Mountain Blend Speciality Coffee Co, a listed company, is the largest coffee wholesaler and roaster in Carvania. At present it is solely involved in importing high quality Arabica coffee from around the world in raw form, and then blending, roasting and packaging the coffees for the consumer market.
Mountain Blend's eight trademarked blends are sold to supermarkets, restaurant chains, cafes and other retailers in Carvania. Although the blends have different aromas and flavours to suit different consumer tastes, the recommended retail price is the same for all the blends, in keeping with Mountain Blend's stated policy and established reputation. In any case the costs related to the production of each blend are very similar.
Since it was formed 30 years ago, in 1979, Mountain Blend has grown from strength to strength. The company's coffee blends and the company itself are well regarded amongst the customers, consumers and investors. However, its share of the market in Carvania has been fairly static over the last three years and the Board of Directors held a meeting two months ago to discuss how to take the company forward into the next decade.
The Board considered two areas that they want to explore further. The first is a possible move into retailing coffee, by producing sophisticated self-service coffee machines and related products. The second is to source the coffee directly from farmers rather than buying from exporters. The Board has requested that an initial report is compiled and presented which considers the two areas discussed.
AREA 1: SELF-SERVICE COFFEE MACHINES
A number of companies manufacture self-service coffee machines where consumers make their own individual selections. The coffee is dispensed within a short period of time. Machines often offer choices between different kinds of coffee like filtered coffee without milk, filtered coffee with milk, espresso, cappuccino, latte, etc. These machines could be located on company premises, in self-service style restaurants, in shopping centres and in railway stations, etc.
Self-service coffee serving machines have had limited success in Carvania to date, with only one local manufacturer manufacturing a small self-service machine offering a limited choice. These machines are only suitable within the premises of small businesses but would not be practical in other locations. At present larger machines offering more choice need to be imported from outside Carvania and these have been expensive to purchase, with a typical machine selling for around 20,000 Carvanian Dollars (C$). Initial surveys by Mountain Blend's marketing department indicate that a model with a current selling price of C$12,000 per machine offering similar or greater choice to that of imported machines would generate significant interest from businesses, both within Carvania and internationally. It is also estimated that there will be scope to increase the selling price of each machine by 5% annually after the first year.
These self-service coffee machines will be able to provide the consumer with a choice of different types of coffee including normal filtered coffee with and without milk, espresso, latte and cappuccino. On top of this, the consumer can choose to add a flavour to their coffee and the machine will offer four flavours: Irish Cream, Vanilla, Chocolate, and Hazelnut.
In addition to producing the machines, Mountain Blend will produce coffee packets for use in the machines but other companies will produce the milk packets and the flavour packets. The company already has sufficient spare capacity to produce the coffee packets in their current facilities. It is estimated that each machine will consume on average a total of 15 packets of coffee in a month and each packet will make a contribution after related costs of C$22. The price and costs related to the production and sale of the packets will increase by a similar amount each year and therefore it can be assumed that the contribution amounts will not change during the next eight years.
Mountain Blend wants to assess the viability of the project based on an eight-year period. It will then decide at a later time about what to do with the business after eight years. Sales of the product for the eight years are estimated as follows:
Year Best case scenario Worst case scenario
1 800 500
2 1,200 800
3 1,800 1,200
4 2,200 2,000
5 4,000 3,800
6 5,000 4,200
7 6,000 4,700
8 6,000 4,700
Following the Board of Directors' meeting and the survey conducted by the marketing department, the finance department commissioned a feasibility study at a cost of C$135,000. The study found that the cost of purchasing suitable land and factory buildings will amount to C$40,000,000. Purchasing and installing a production facility will cost C$10,000,000 in total. All these costs would be payable at the start of the project.
Each production facility will be able to produce 3,500 units per year. Installing further production facilities will cost C$10,000,000 each and there will be no inflation on these for the foreseeable future. The purchase and installation of the production facilities is rapid and production can commence within a few days. There will be enough space on the factory premises to hold two production facilities.
Mountain Blend will operate a policy of depreciating the production facilities on a straight-line basis from the first year, over the eight-year period, and an assumption can be made that fully depreciated production facilities will not have a resale value at the end of the project. When the project ends, it can be assumed that the land and buildings will be worth C$40,000,000 and production facilities which are not depreciated fully, can be sold at their net book value.
The production of each self-service coffee machine will require the three types of materials: metal parts and electrical components, plastic parts and rubber parts. Current materials cost per machine are estimated as follows:
Metal parts and electrical components C$2,525
Plastic parts C$925
Rubber parts C$530
In addition to this, in the first two years of production, materials costs need to be increased by 10% per year to take account of wastage and damages during manufacturing. This can then be reduced to 5% per year for the remaining period. It has also been estimated that metal parts and electrical components will be subject to an annual inflation of 10% and plastic parts and rubber parts to an annual inflation of 5%, both taking effect after the first year.
Each self-service coffee machine will also require two grades of labour in the manufacturing process: Grade A and Grade B. Grade A labour is currently paid C$30 per hour and 32 hours are required to make each machine. Grade B labour is currently paid C$42 per hour and 24 hours are required to make each machine. In addition to this, it is estimated that an additional down-time allowance of 6% on time required for manufacturing will need to be made for both the grades of labour. Training costs in the first year of manufacture will be 15% of the labour costs spent in the
manufacturing process (inclusive of the downtime allowance), reducing to 10% in the second year and to 5% per year thereafter. Annual increases in wages for the two grades are estimated as follows: Grade A 5% and Grade B 7% after the first year.
It is estimated that variable overheads will be 40% of the total labour costs. Variable overheads include the cost of packaging, freight and insurance. Fixed overheads are currently estimated to be C$8,000,000 per year. Of these, C$3,000,000 relate directly to the manufacture and sale (including sales and marketing related expenses) of the self-service machines and the remainder are allocated overheads. It is estimated that fixed costs will increase by 5% per year after the first year.
In addition to the above costs, at the start of each year, the company will need to make working capital available of 20% of the value of anticipated machine sales for that year, to cover for inventories, trade receivables and cash flows. It can be assumed that all the working capital will be released at the end of the eight years of manufacturing.
Mountain Blend pays tax on taxable profits at 20% and tax is paid in the year incurred. Based on a simplified method, Mountain Blend estimates the taxable profits as sales revenue less variable costs (including materials, labour and variable overheads), non-allocated fixed overheads and capital allowances. Depreciation is not included as part of the costs.
The tax authorities in Carvania will allow Mountain Blend to write off capital allowances at 10% on a straight-line basis on each production facility from the year the manufacturing process commences. At the time of disposal of the production facility, any additional value not written off can be allowed as a balancing allowance or if too much has been written off then a balancing charge will be payable. No capital allowances will be available on land or buildings.
In order to determine an appropriate cost of capital for the venture, Mountain Blend is considering using the capital asset pricing model (CAPM). Mountain Blend's equity beta has been in the region of 0·9 over the past three years. This venture can be considered to be outside Mountain Blend's normal business activities to date. The equity beta of a company selling self-service coffee machines based in Germany has been estimated at 1·1. The German company's debt to equity ratio in market value terms is 30:70 and it also pays tax at around 20%. Mountain Blend's debt to equity ratio is currently closer to 50:50 in market value terms. Since this is a new venture for Mountain Blend, it is estimated that the return on equity required by the shareholders will be 2·70% higher than one that is calculated based on CAPM only.
Historically the stock market yield in Carvania has been around 12% per year. The current Government Treasury Bill rate is 5% and is likely to remain so for the foreseeable future.
In order to purchase the land, build the factory and install the production facilities, it is proposed that Mountain Blend raise the required finance either through a secured loan note issue or a small rights issue.
Kurmon Co, a company based in South East Asia, has approached Mountain Blend with a proposal of supplying the machines. Kurmon Co would produce the machines in South East Asia to Mountain Blend's specifications and ship them ready packaged. Kurmon Co is willing to supply the machines to Mountain Blend priced at C$10,500, for the first year, and increasing at 5% p.a. thereafter.
The main benefits to Mountain Blend would be that there are no upfront costs of purchasing the land, buildings and manufacturing units. Also the company would not incur any materials, labour and variable overhead costs. Non-allocated annual fixed overheads would reduce to C$2,000,000 at current prices, although they would still be subject to a 5% annual inflationary increase after the first year. These costs relate to marketing and sales activity and to other costs like inspection, local transportation, etc. Mountain Blend would still need to invest an equivalent amount in working capital and this will be released at the end of the project as before.
Under this option, Mountain Blend would be able to meet the additional funding requirements from its cash reserves and current credit lines, and no additional external funding will be required.
AREA 2: KAZAMBIAN COFFEE FARMERS' CONSORTIUM
Given the uncertainty surrounding the revenues the farmers in Kazambia are receiving due to external markets and internal practices (see briefing notes), two large coffee producers and several smaller coffee producers recently formed a consortium (Kazambian Coffee Farmers' Consortium (KCFC)) to try and find ways to improve their revenues.
Representatives of KCFC have approached Mountain Blend with a proposal to supply coffee directly to Mountain Blend.
Currently, coffee from Kazambia is sold to Mountain Blend through exporters. Mountain Blend instructs the exporters to buy the coffee from a weekly auction based on agreed criteria. The exporters arrange for the coffee to be transported to port and loaded on the cargo ship, including insuring the coffee until it is on the ship. Mountain Blend then arranges for the coffee to be shipped to Carvania, including paying for the freight, insurance and other costs. This arrangement is commonly known as free-on-board (FOB).
Mountain Blend has estimated a cost profile per kilo of coffee from Kazambia based on using the services of an exporter.
Although Mountain Blend sells a kilo of normal roasted coffee for C$50, an equivalent price for a kilo of roasted Kazambian coffee would be C$58 due to its superior quality. About 20% of the C$58 price is Mountain Blend's profit margin, which is higher than its average operating profit margin (see briefing note 5). The cost of blending, roasting and packaging is 25% of the price, and overheads account for another 23% of the price. The remainder relates to the coffee raw material purchase cost, the transportation costs from Kazambia to Carvania and the exporter's costs and margins.
Mountain Blend estimates that, due to the wastage of coffee in the quality assessment, roasting and packaging processes, it needs to purchase 20·5% more coffee than the amount it needs to produce. The coffee imported from Kazambia and the shipping freight (and related costs such as insurance) are paid for in US$ and the current rate is C$2·2 per 1US$.
Based on the current auction prices, Mountain Blend estimates that the exporter charges 20% of the coffee cost at the auction to cover their margins and FOB costs. Mountain Blend would incur a further 20% of the coffee cost at the auction for shipping and related costs to get the coffee to Carvania. It has also estimated that the farmers currently receive 50% of the price of coffee the auction fetches, with the other 50% retained by the millers for their processing costs and margins.
KCFC's proposal is to arrange for the coffee pods to be picked, dried and transported to a miller, who would extract the beans from the pods and pack them for transportation. The coffee would then be transported through a clearing company based in Kazambia, with a branch in Port Rondo, from where the coffee will be shipped. After the coffee is put onto a ship, Mountain Blend would follow its normal procedures to get the coffee transported to Carvania for blending and roasting.
Mountain Blend would pay an additional 50% more revenue to the farmers per kilo, compared to what the farmers receive from the auction based on current auction prices for a fixed period of five years. This amount would then not fluctuate even if world coffee prices do. The farmers would be guaranteed a generous and stable price for their coffee. KCFC would find a suitable miller and a clearing company for Mountain Blend to arrange the transportation of the coffee for shipment. It would be Mountain Blend's responsibility to pay for the milling and transportation costs. Milling and preparation costs are estimated to be US$1·03 per kilo and transportation costs are estimated at US$0·22 per kilo.
Apart from the savings Mountain Blend will make on the auction prices and on the exporter related costs, it is anticipated that the other costs will remain the same as when the coffee was bought using the exporter's services.
Required: Prepare a report for the Board of Directors of Mountain Blend addressing the two areas discussed in the board meeting as follows:
(a) Evaluate the proposal to sell self-service coffee machines over the eight year period. Include in the evaluation:
(i) Calculations (to be included in the appendices) of the net present value of the proposed venture, whether the machines are produced in house or by Kurmon Co on Mountain Blend's behalf, under both best case and worst case scenarios.
(ii) Explain the assumptions made when computing the net present values
(iii) Comment on and discuss whether Mountain Blend should undertake the project (whether manufactured in-house or by Kurmon Co) and how it should be funded. Include in the discussion a description of the risks associated with the venture and how they might be dealt with.
(b) Calculate the impact on Mountain Blend's profit from purchasing a kilo of coffee from KCFC and not from the auction. Discuss other benefits and risks associated in dealing with the KCFC direct rather than with coffee exporters.