Aunt Sally's Food Inc. is considering expansion. Sally has paid $100,000 for a marketing study to assist in the potential valuation. The study indicates that the new product will have sales of $1,500,000 per year each year for the next 6 years. However, existing product line sales will be adversely affected by about $200,000 per year. Equipment will cost $1,100,000 and will be depreciated on the straight-line method with no salvage value at the end of 6 years. Annual fixed costs are $160,000 per year and variable costs are 60% of annual sales. Also, initial working capital outlay of $150,000 will be required which will be recaptured at the end of the 6 years. Sally's tax rate is 35%. The firm requires an 18% return. Sally also requires a 25% after tax return on an accounting basis.

Question

Aunt Sally's Food Inc. is considering expansion. Sally has paid $100,000 for a marketing study to assist in the potential valuation. The study indicates that the new product will have sales of $1,500,000 per year each year for the next 6 years. However, existing product line sales will be adversely affected by about $200,000 per year. Equipment will cost $1,100,000 and will be depreciated on the straight-line method with no salvage value at the end of 6 years. Annual fixed costs are $160,000 per year and variable costs are 60% of annual sales. Also, initial working capital outlay of $150,000 will be required which will be recaptured at the end of the 6 years. Sally's tax rate is 35%. The firm requires an 18% return. Sally also requires a 25% after tax return on an accounting basis.

I NEED TO FIND 1)NET PRESENT VALUE, 2) INTERNAL RATE OF RETURN AND 3) AVERAGE ACCOUNTING RETURN

Answer 1

To find the net present value (NPV), internal rate of return (IRR), and average accounting return, you will need to analyze the cash flows associated with the expansion project over the 6-year period. Here's how to calculate each metric:

1) Net Present Value (NPV):
The NPV represents the present value of expected cash flows associated with the project, discounted back to the present at the required rate of return. Here are the steps to calculate NPV:

Step 1: Calculate annual cash flows:
- Calculate the after-tax cash flow by subtracting variable costs and fixed costs (including depreciation) from annual sales.
- Subtract the adverse effect on existing product line sales.
- Add back the annual depreciation.
- Calculate the after-tax cash flow by multiplying the result with (1 - tax rate).

Step 2: Calculate the discounted cash flows:
- Apply the discount rate (required rate of return) to each annual cash flow using the present value formula.
- Sum up the discounted cash flows.

Step 3: Subtract the initial investment:
- Subtract the initial investment (equipment cost + working capital) from the sum of the discounted cash flows.

The resulting amount is the net present value of the expansion project.

2) Internal Rate of Return (IRR):
The IRR is the discount rate that makes the NPV equal to zero. To calculate the IRR, you can use Excel or financial calculators that have the IRR function. Alternatively, you can use trial and error by iteratively trying different discount rates until the NPV equals zero.

3) Average Accounting Return:
The average accounting return measures the average annual profitability of an investment over its life. It is calculated as the average annual after-tax income divided by the average investment. Here's how to calculate it:

Step 1: Calculate the average annual after-tax income:
- Subtract the annual fixed costs (including depreciation) from the annual sales.
- Multiply the result by (1 - tax rate).
- Divide the result by the number of years.

Step 2: Calculate the average investment:
- Add the initial investment and the terminal value (working capital recaptured) at the end of the 6 years.
- Divide the result by 2.

Step 3: Divide the average annual after-tax income by the average investment.

The resulting percentage is the average accounting return.

By following these steps, you can compute the net present value, internal rate of return, and average accounting return for Aunt Sally's Food Inc.'s expansion project.