A manufacturing company is thinking of launching a new product. The company expects to sell $950,000 of the new product in the first year and $1,500,000 each year thereafter. Direct costs including labor and materials will be 45% of sales. Indirect incremental costs are estimated at $95,000 a year. The project requires a new plant that will cost a total of $1,500,000, which will be a depreciated straight line over the next 5 years. The new linewill also require an additional net investment in inventory and receivables in the amount of $200,000. Assume there is no need for additional investment in building the land for the project. The firm's marginal tax rate is 35%, and its cost of capital is 10%.
Using the information,
Prepare a statement showing the incremental cash flows for this project over an 8-year period.
Calculate the payback period (P/B) and the net present value (NPV) for the project.
Answer the following questions based on your P/B and NPV calculations: Do you think the project should be accepted? Why?
Assume the company has a P/B (payback) policy of not accepting projects with life of over 3 years.
If the project required additional investment in land and building, how would this affect your decision? Explain.
To prepare a statement showing the incremental cash flows for the project over an 8-year period, we need to consider the following elements:
1. Year 0 (Initial Investment):
- New plant cost: $1,500,000
2. Years 1-8 (Annual Cash Flows):
- Sales revenue:
- Year 1: $950,000
- Years 2-8: $1,500,000
- Direct costs:
- Year 1: 45% of sales
- Years 2-8: 45% of sales
- Indirect incremental costs: $95,000 per year
- Depreciation (straight-line) of new plant:
- Year 1: $1,500,000 / 5
- Years 2-8: $1,500,000 / 5
- Net investment in inventory and receivables: $200,000 (only in Year 0)
To calculate the payback period (P/B) and net present value (NPV), we can follow these steps:
1. Calculate the cumulative cash flows for each year by subtracting the direct costs, indirect costs, and depreciation from the sales revenue.
- For Year 1: Cumulative cash flow = Sales revenue - Direct costs - Indirect costs - Depreciation
- For Years 2-8: Cumulative cash flow = Sales revenue - Direct costs - Indirect costs - Depreciation + Cumulative cash flow of the previous year
2. Calculate the payback period by finding the year in which the cumulative cash flows turn positive. The payback period is the number of years it takes to recover the initial investment (Year 0).
3. Calculate the net present value (NPV) by discounting the cash flows to the present value using the company's cost of capital (10%) and subtracting the initial investment.
- For Year 0: NPV = -Initial investment
- For Years 1-8: NPV = Cumulative cash flow / (1 + Cost of capital)^year - Initial investment
Based on the payback period (P/B) and net present value (NPV) calculations, we can determine whether the project should be accepted.
If the payback period is less than or equal to the company's policy of not accepting projects with a life over 3 years, and the net present value is positive, then the project should be accepted. Otherwise, if either of these conditions is not met, the project should be rejected.
If the project required additional investment in land and building, it would affect the decision by increasing the initial investment. This would reduce the net present value (NPV) of the project because the higher initial investment would decrease the cash flows available for discounting. Thus, the decision to accept or reject the project would depend on whether the adjusted NPV meets the company's acceptance criteria.