Besty's Best

Case Background

In the early 1990s, Bruce Pitston, operated one of the largest operations in north Wisconsin, believed that a dairy manufacturing plant using advanced technology for designer cheese and other milk products may diversify the local economy. Sam Lund, the plant manager and a native, also expressed an interest in helping to develop the new operation. Bruce then returned home and succeeded to convince other dairy farmer about that idea.

In 1998, the top dairy farmers formed Betsy’s Best Co-op and in 2002, Betsy’s Best opened a $35 million production facility. They bought state-of-the-art processing equipment and produced a variety of dairy products for retail grocery stores, and packaged it under customers’ store labels. Due to the high start-up costs, the co-op didn’t expect to make a profit for 3 years but at the end of the 2nd year, the plant had profits of $1.5 million.

After 2 years of production, the company ships most of the retail product to the central section of the US. Because of high quality products, they were allowed to expand sales. Annual output has jumped to 17 million pounds and the plant was running at capacity.

However, the strong demand leads to a difficulty that Betsy’s Best can’t satisfy existing customers on a timely basis and some customers might switch suppliers for a reliable shipment of goods. Concerned about the potential loss of customers, Betsy’s Best was suggested to purchase a second production machine for $37.5 million. They believe that the new machine will increase cheese sales by 8 million pounds per year and the fixed operating costs to increase by $700,000. Local interest for the expansion is strong, and they indicated that a large portion of the required money can be obtained by a second stock offering, the remainder can be obtained through a collateralized loan from the bank.

To guarantee a timely supply of product, Betsy’ Best is about to rent a warehouse in Chicago, which can be leased for 10 years at the rate of $105,000 per year. The company expects that the longer runs will boost existing machinery production by 1.5 million pounds.

Betsy’s Best faces another capital budgeting issue: replacing the packaging and labeling machine. The current machine is slow and produces many defective labels, while there are new processes with increased flexibility and speed. The two best labeling options include a three-year economic life machine and a five-year economic life machine. Through a special tax designation, both options fall under the 3-year MACRS recovery period.

Case Resolution

Question 1: Define the term “incremental cash flow”. Since the company will finance the project in part of debt, should the cash flow statement include the interest expenses? Explain?

Answer:

“Incremental cash flow” is the