Assignment task: Capital Budgeting and Cash Flow Estimation
Allied Food Products 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 Allied's Fort Myers plant; Allied owns the building, which is fully depreciated. The purchase price of the required equipment is $280,000, including shipping and installation costs, and the equipment is eligible for 100% bonus depreciation at the time of purchase. In addition, inventories would rise by $25,000, while accounts payable would increase by $5,000. All of these costs would be incurred at t = 0.
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 units per year, and the expected sales price is $2.00 per unit. Cash operating costs for the project are expected to total 60% of dollar sales. Allied's tax rate is 25%, and its WACC is 10%. Tentatively, the lemon juice project is assumed to be of equal risk to Allied'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 gave you the following set of tasks/questions:
1. What is the primary weakness of sensitivity analysis? What are its primary advantages?
2. Unrelated to the lemon juice project, Allied is upgrading its plant and must choose between two machines that are mutually exclusive. The plant is highly successful, so whichever machine is chosen will be repurchased after its useful life is over. Both machines have an after-tax cost of $50,000; however, Machine A provides aftertax savings of $17,500 per year for 4 years, while Machine B provides after-tax savings of $34,000 in Year 1 and $27,500 in Year 2.
a. Using the replacement chain method, what is the NPV of the better machine?
b. Using the EAA method, what is the EAA of the better machine?
Work out quantitative answers to the remaining questions only if your instructor asks you to. Also note that it will take a long time to do the calculations unless you are using an Excel model.
3. Assume that inflation is expected to average 5% over the next 4 years and that this expectation is reflected in the WACC. Moreover, inflation is expected to increase revenues and variable costs by this same 5%. Does it appear that inflation has been dealt with properly in the initial analysis to this point? If not, what should be done and how would the required adjustment affect the decision?