A manufacturing firm is thinking of launching a new product. The firm 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 line will also require an additional net investment in inventory and receivables in the amount of $200,000.

Question

A manufacturing firm is thinking of launching a new product. The firm 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 line will 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%.
To receive full credit on this include formulas and calculations used to arrive at financial values.
Guidelines:
• Using the information above
o Prepare a statement showing the incremental cash flows for this project over an 8-year period. (Similar to an income statement)
o Calculate the payback period (P/B), net present value (NPV), IRR and discounted payback period for the project.
o 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.

Answer 1

To begin, let's prepare a statement showing the incremental cash flows for this project over an 8-year period.

Year 1:
Sales: $950,000
Direct costs: 45% * $950,000 = $427,500
Indirect costs: $95,000
Depreciation: $1,500,000 / 5 = $300,000
Net investment: $200,000
Cash flow: (Sales - Direct costs - Indirect costs - Depreciation) + Net investment = ($950,000 - $427,500 - $95,000 - $300,000) + $200,000 = $327,500

Years 2-8:
Sales: $1,500,000
Direct costs: 45% * $1,500,000 = $675,000
Indirect costs: $95,000
Depreciation: $1,500,000 / 5 = $300,000
Net investment: $200,000
Cash flow: (Sales - Direct costs - Indirect costs - Depreciation) + Net investment = ($1,500,000 - $675,000 - $95,000 - $300,000) + $200,000 = $630,000

Now let's calculate the payback period (P/B), net present value (NPV), internal rate of return (IRR), and discounted payback period for the project.

Payback period (P/B):
The payback period is the time it takes for the project to recoup its initial investment. To calculate the payback period, we need to accumulate the cash flows until they equal or exceed the initial investment of $1,500,000.

Year 1: $327,500
Year 2: $327,500 + $630,000 = $957,500
Year 3: $957,500 + $630,000 = $1,587,500

The payback period falls within year 3.

Net present value (NPV):
The net present value calculates the present value of all cash flows and subtracts the initial investment. The formula for NPV is:

NPV = ∑ (Cash flow / (1 + Cost of capital)^t) - Initial investment

Using a discount rate of 10%, we can calculate the NPV as follows:

NPV = ($327,500 / (1 + 0.1)^1) + ($630,000 / (1 + 0.1)^2) + ($630,000 / (1 + 0.1)^3) + ... + ($630,000 / (1 + 0.1)^8) - $1,500,000

IRR (Internal Rate of Return):
The internal rate of return is the discount rate that makes the net present value equal to zero. A higher IRR indicates a better return on investment. We can use a financial calculator or software to find the IRR.

Discounted payback period:
Similar to the payback period, the discounted payback period accumulates the discounted cash flows until they equal or exceed the initial investment. We need to calculate the discounted cash flows using the formula:

Discounted Cash Flow = Cash flow / (1 + Cost of capital)^t

Then, we accumulate the discounted cash flows until they reach or exceed the initial investment.

Let's move on to answering the following questions based on the P/B and NPV calculations:

1. Do you think the project should be accepted? Why?
To determine whether the project should be accepted, we need to consider the payback period and NPV.

The payback period of 3 years falls within the company's policy of not accepting projects with a life of over 3 years. However, the payback period alone does not provide a comprehensive evaluation.

The NPV calculation takes into account the time value of money and provides a better measure of the project's profitability. If the NPV is positive, it indicates that the project is expected to generate more value than the initial investment. Therefore, if the NPV is positive, the project should be accepted.

2. Assume the company has a payback policy of not accepting projects with a life of over 3 years.
In this case, since the payback period of the project is within 3 years, it meets the company's policy and can be accepted based on that criterion alone.

3. If the project required additional investment in land and building, how would this affect your decision? Explain.
If the project required additional investment in land and building, it would increase the initial investment and potentially affect the payback period and NPV calculations.

A higher initial investment would increase the payback period as more cash flows need to accumulate to cover the investment. It could also decrease the NPV if the additional investment does not generate enough returns to offset the cost.

Considering the impact on the payback period and NPV, the decision to accept the project would depend on whether the adjusted payback period still falls within the company's policy and if the adjusted NPV remains positive or acceptable.