ABC Company is considering expanding into the fruit juice business with a new fr
ID: 2791619 • Letter: A
Question
ABC Company is considering expanding into the fruit juice business with a new fresh lemon juice product. 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 ABC’s Fort Myers plant; ABC owns the building, which is fully depreciated. The required equipment would cost $400,000, plus an additional $40,000 for shipping and installation. In addition, inventories would rise by $40,000, while accounts payable would increase by $5,000. All of these costs would be incurred on day 1 of the project approval. ABC elects to depreciation the equipment using the straight line method of depreciation over a 10-year property.
The project should be evaluated over a 10 year period of operation at which time it is assumed to be terminated. The cash inflows are assumed to begin 1 year after the project is undertaken and to continue out to year 10. At the end of the project’s life, the equipment is expected to have a salvage value of $35,000. Unit sales are expected to total 15,000 units per year for years 1 thru 5 and then 20,000 per year thereafter; the expected sales price is $10 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 45% of dollar sales.
ABC’s tax rate is 40%, and its only capital is equity and the required return is 10% so its overall WACC is 10%. Tentatively, the lemon juice project is assumed to be of equal risk to ABC’s other assets. You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected. To guide you in your analysis, your boss made the following suggestions/recommendations:
a.Create a project evaluation schedule (ideally in Excel) of the relevant income statement and cash flow items needed to evaluate the project - including the initial investment outlay, revenues, operating costs, terminal cash flows, etc. (Submit your Excel file via as an email attachment after you submit your responses in this Word document).
b.Complete the depreciation calculation and schedule and include the annual amount as appropriate in the project evaluation schedule. (You may add the depreciation schedule here or include it in the Excel file in letter a.)
Discuss the recovery of net operating working capital. What would have happened if the machinery had been sold for less than its book value?
If ABC had used debt in its capital structure and some of the money used to finance the project was debt. Should the projected cash flows be revised to show projected interest charges? Why or Why not? Would the project cash flows change, would the WACC change, neither or both?
Suppose you learned that ABC could lease its building to another party and earn $25,000 per year. Should that fact be reflected in the analysis? If so, how/how much?
Assume that the lemon juice project would take profitable sales away from ABC’s fresh orange juice business. Should that fact be reflected in your analysis? If so, how?
If this project had been a replacement rather than an expansion project, how would the analysis have changed and why? What additional information would you need to complete this analysis?
What three levels, or types, of project risk are normally considered? Which type is most relevant? Are the three types of risk generally highly correlated?
What is sensitivity analysis?
How would you perform a sensitivity analysis on the unit sales, salvage value, and WACC for the project?
Assume that sales units and equipment cost each deviate from its assumed value (above) by plus or minus 10%. Explain, but don’t actually do the calculations, how you would calculate the NPV, IRR and payback for each case. (Optional: submit the plus/minor 10% sensitivity analysis for extra credit using Excel)
What is the primary weakness of sensitivity analysis? What are its primary advantages?
Should any subjective risk factors be considered before the final decision is made? Explain
IMPORTANT: Assume that ABC decides to finance the project with 40% Debt and 60% Equity and that the after-tax cost of debt is 9.2% instead of 10%. How would affect the decision to accept the project? What would be the next NPV, IRR and PBP? (To support your answers you may include a separate Excel calculation spreadsheet)
Explanation / Answer
As per rules, I will answer the first 4 sub parts of the question
a & b: Depreciation is 1/10th of $440000. Initial cost of equipment will include installation cost.
c. The working capital is assumed to have been recovered at the end of year 10. This is because when the project is over, we assume that all investment in inventory is received and accounts payables are paid off. Working capital = Current assets - Current liabilities = 40000-5000 = 35000. The equipment is fully depreciated which means its books value is zero. It cannot be sold for less than its book value. Whatever amount it is sold for will be capital gains and hence 40% tax will be deducted from it.
d. If debt was used in the capital structure, we would not revise the cash flows. We do not take into account the interest payment in computation of NPV. Rather the cost of capital= WACC would change to incorporate the impact of the cost of debt.
(NPV can be computed as = NPV(WACC%, Cash flows years 1-10)+ Initial cash flow
At 10%, NPV = -$2271.75 )
Year Equipment cost Working capital Salvage=35000*60% Cash flows Net cash flow 0 $(440,000.00) $ (35,000.00) $(475,000.00) 1 $ 67,100.00 $ 67,100.00 2 $ 67,100.00 $ 67,100.00 3 $ 67,100.00 $ 67,100.00 4 $ 67,100.00 $ 67,100.00 5 $ 67,100.00 $ 67,100.00 6 $ 83,600.00 $ 83,600.00 7 $ 83,600.00 $ 83,600.00 8 $ 83,600.00 $ 83,600.00 9 $ 83,600.00 $ 83,600.00 10 35000 21000 $ 83,600.00 $ 139,600.00 Year Revenue Costs= Sales *45% Depreciation PBT Tax=PBT*40% Net iNcome Cash flows post tax=Net Income + Depreciation 1 150000 -67500 $ (44,000.00) 38500 -15400 23100 $ 67,100.00 2 150000 -67500 $ (44,000.00) 38500 -15400 23100 $ 67,100.00 3 150000 -67500 $ (44,000.00) 38500 -15400 23100 $ 67,100.00 4 150000 -67500 $ (44,000.00) 38500 -15400 23100 $ 67,100.00 5 150000 -67500 $ (44,000.00) 38500 -15400 23100 $ 67,100.00 6 200000 -90000 $ (44,000.00) 66000 -26400 39600 $ 83,600.00 7 200000 -90000 $ (44,000.00) 66000 -26400 39600 $ 83,600.00 8 200000 -90000 $ (44,000.00) 66000 -26400 39600 $ 83,600.00 9 200000 -90000 $ (44,000.00) 66000 -26400 39600 $ 83,600.00 10 200000 -90000 $ (44,000.00) 66000 -26400 39600 $ 83,600.00