Capital Budgeting and Cash Flow Estimation After
seeing Snapple’s success with noncola soft drinks and learning
of Coke’s and Pepsi’s interest, Allied Food Products has
decided to consider an expansion of its own in the fruit juice
business. The product being considered is fresh lemon juice.
Assume that you were recently hired as assistant to the director
of capital budgeting, and you must evaluate the new
project.
The lemon juice would be produced in an unused building
adjacent to Allied’s Fort Myers plant; Allied owns the
building, which is fully depreciated. The required equipment
would cost $200,000, plus an additional $40,000 for
shipping and installation. In addition, inventories would rise
by $25,000, while accounts payable would go up by $5,000.
All of these costs would be incurred at t = 0. By a special
ruling, the machinery could be depreciated under the
MACRS system as 3-year property. The applicable depreciation
rates are 33%, 45%, 15%, and 7%.
The project is expected to operate for 4 years, at which
time it will be terminated. The cash inflows are assumed to
begin 1 year after the project is undertaken, or at t = 1, and to
continue out to t = 4. At the end of the project’s life (t = 4),
the equipment is expected to have a salvage value of $25,000.
Unit sales are expected to total 100,000 cans per year, and
the expected sales price is $2.00 per can. Cash operating costs
for the project (total operating costs less depreciation) are
expected to total 60 percent of dollar sales. Allied’s tax rate is
40 percent, and its weighted average cost of capital is 10 percent.
Tentatively, the lemon juice project is assumed to be of
equal risk to Allied’s other assets.
You have been asked to evaluate the projects and to make
a recommendation as to whether it should be accepted or rejected.
To guide you in your analysis, your boss gave you the
following set of questions.
a. Draw a time line that shows when the net cash inflows
and outflows will occur, and explain how the time line
can be used to help structure the analysis.
b. Allied has a standard form that is used in the capital budgeting
process; see Table IC11-1. Part of the table has been
completed, but you must replace the blanks with the missing
numbers. Complete the table in the following steps:
(1) Fill in the blanks under Year 0 for the initial investment
outlay.
(2) Complete the table for unit sales, sales price, total
revenues, and operating costs excluding depreciation.
(3) Complete the depreciation data.
(4) Now complete the table down to operating income
after taxes, and then down to net cash flows.
(5) Now fill in the blanks under Year 4 for the terminal
cash flows, and complete the net cash flow line. Discuss
net operating working capital. What would have
happened if the machinery were sold for less than its
book value?
c. (1) Allied uses debt in its capital structure, so some of the
money used to finance the project will be debt. Given
this fact, should the projected cash flows be revised to
show projected interest charges? Explain.
(2) Suppose you learned that Allied had spent $50,000 to
renovate the building last year, expensing these costs.
Should this cost be reflected in the analysis? Explain.
(3) Now suppose you learned that Allied could lease its
building to another party and earn $25,000 per year.
Should that fact be reflected in the analysis? If so, how?
(4) Now assume that the lemon juice project would take
away profitable sales from Allied’s fresh orange juice
business. Should that fact be reflected in your analysis?
If so, how?
d. Disregard all the assumptions made in part c, and assume
there was no alternative use for the building over the next
4 years. Now calculate the project’s NPV, IRR, MIRR,
and regular payback. Do these indicators suggest that the
project should be accepted?
I have done most of them but can not figure out the ones above.
a. To draw a time line showing the net cash inflows and outflows, you need to identify the relevant cash flows for each period. In this case, the project is expected to operate for 4 years. The initial investment outlay occurs at t = 0, and the cash inflows start at t = 1 and continue until t = 4. At the end of the project's life (t = 4), there is a terminal cash flow. By drawing a time line, you can visually see the timing of the cash flows and use this information to structure the analysis.
b. To complete the table in Table IC11-1, you need to fill in the missing numbers for each year. Here are the steps to complete the table:
1. Fill in the blanks under Year 0 for the initial investment outlay. The initial investment outlay includes the cost of equipment, shipping and installation, changes in inventories, and changes in accounts payable.
2. Complete the table for unit sales, sales price, total revenues, and operating costs excluding depreciation. Given that unit sales are expected to total 100,000 cans per year and the expected sales price is $2.00 per can, you can calculate the total revenues for each year. The cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales, so you can calculate the operating costs excluding depreciation.
3. Complete the depreciation data. The machinery can be depreciated under the MACRS system as 3-year property using the applicable depreciation rates of 33%, 45%, 15%, and 7%. Apply the depreciation rates to the initial investment in equipment to calculate the depreciation expense for each year.
4. Complete the table down to operating income after taxes, and then down to net cash flows. Operating income after taxes can be calculated by subtracting the tax expense from the operating income. The tax expense can be calculated by multiplying the operating income by the tax rate. Net cash flows can be calculated by subtracting the depreciation expense from the operating income after taxes.
5. Fill in the blanks under Year 4 for the terminal cash flows, and complete the net cash flow line. At the end of the project's life (t = 4), the equipment is expected to have a salvage value of $25,000. Include this salvage value as the terminal cash flow for Year 4. Complete the net cash flow line by summing up the net cash flows for each year.
c. (1) The projected cash flows should not be revised to show projected interest charges. The interest charges are part of the financing decision and do not impact the cash flows generated by the project. Cash flows should only reflect the operating income generated by the project.
(2) The renovation cost of $50,000 incurred last year should not be reflected in the analysis. These costs have already been expensed and should not be considered as part of the future cash flows of the project.
(3) The fact that Allied could lease its building to another party and earn $25,000 per year should be reflected in the analysis. This additional cash inflow should be included as a positive cash flow in each year of the project.
(4) If the lemon juice project would take away profitable sales from Allied's fresh orange juice business, this fact should be reflected in the analysis. The impact can be estimated by considering the lost revenues from the fresh orange juice business and subtracting them from the total revenues of the lemon juice project.
d. To calculate the project's NPV, IRR, MIRR, and regular payback, you need to use the projected cash flows. Disregard the assumptions made in part c, and assume there was no alternative use for the building over the next 4 years. Use the projected cash flows to calculate the NPV, IRR, MIRR, and regular payback. Compare these indicators to the required minimum rate of return or a predetermined investment criterion to determine if the project should be accepted.