Return to the initial inflation assumptions (5 percent on price and 2 percent on cash operating
costs)Indian River Citrus Company (B)
Capital Budgeting
Directed
© 1994 South-Western, a part of Cengage Learning
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response were strong, then sales volume for Year 1 would be 650,000 units. In all cases, the price
would increase at the inflation rate; hence, Year 1 revenues stated in Year 1 dollars, as they would
appear on the cash flow statement, would be $892,500 under the expected conditions, they would
be only $420,000 if things went badly, and they would amount to $1,365,000 if things went espe-
cially well. Cash costs per unit would remain at $1.50 before adjusting for inflation, so total cash
operating costs in Year 1 would be approximately $650,250 under normal conditions, $306,000 in
the worst-case scenario, and $994,500 in the best-case scenario. These costs would be expected to
increase in each successive year at a 2 percent rate.
Lili and Brent also discussed the scenarios’ probabilities with the marketing staff. After con-
siderable debate, they finally agreed on a “guesstimate” of 25 percent probability of poor acceptance,
50 percent probability of average acceptance, and 25 percent probability of excellent acceptance.
Lili and Brent also discussed with Victor Courtland, Indian River’s director of capital bud-
geting, both the risk inherent in Indian River’s average project and how the company typically
adjusts for risk. Based on historical data, Indian River’s average project has a coefficient of variation
of NPV in the range of 0.50 to 1.00, and Courtland has been adding or subtracting 3 percentage
points to the cost of capital to adjust for differential project risk. When Lili and Brent asked about the
basis for the 3 percentage point adjustment, Courtland stated that the adjustment apparently had no
basis...