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 required equipment would cost $450,000, plus an additional $38,000 for shipping and installation. In addition, inventories would rise by $40,000, while accounts payable would increase by $10,000. All of these costs would be incurred at t = 0. By a special ruling, the machinery could be depreciated under the MACRS system as 4-year property. The applicable depreciation rates are 40%, 30%, 20%, and 10%. 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 (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 $45,000. Unit sales are expected to total 195,000 units per year, and the expected sales price is $1.60 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 40% of dollar sales. Allied’s tax rate is 23%, and its WACC is 12%. Tentatively, the lemon juice project is assumed to be of equal risk to Allied’s other assets. PART D Expected inflation 8% Years 0 1 2 3 4 I. Investment Outlays Equipment cost ($450,000) Installation (38,000) CAPEX ($488,000) Increase in inventory (40,000) Increase in Account Payable 10,000 ΔNOWC ($30,000) II. Project Operating Cash Flows Unit sales 195,000 195,000 195,000 195,000 Price per unit $ 1.728 $ 1.866 $ 2.015 $ 2.176 Total revenues 336,960 363,917 392,925 424,473 Operating costs (w/o deprn) 134,784 145,566 157,170 169,789 Depreciation 195,200 146,400 97,600 48,800 Total costs $ 329,984 $ 291,966 $ 254,770 $ 218,589 EBIT (Operating income) $ 6,976 $ 71,951 $ 138,155 $ 205,884 Taxes on operating income 1,604 16,549 31,776 47,353 EBIT (1 ‒ T) = Aafter tax operating income $ 5,372 $ 55,402 $ 106,379 $ 158,531 Add back depreciation 195,200 146,400 97,600 48,800 EBIT (1 ‒ T) + DEP $ 200,572 $ 201,802 $ 203,979 $ 207,331 III. Terminal Year Cash Flows Salvage value 45,000 Tax on salvage value 10,350 After-tax salvage value 34,650 Recovery of NOWC 30,000 Project Free Cash Flows = ($518,000) $200,572 $ 201,802 $ 204,028 $271,980 EBIT(1-T) + DEP - CAPEX - ΔNOWC Assume that you are confident about the estimates of all the variables that affect the cash flows except unit sales. If product acceptance is poor, sales would be only 65,000 units a year, while a strong consumer response would produce sales of 240,000 units. In either case, cash costs would still amount to 40% of revenues. You believe that there is a 35% chance of poor acceptance, a 15% chance of excellent acceptance, and a 50% chance of average acceptance (the base case). 1. What is the worst-case NPV? The best-case NPV? Hint: you should consider the 8% inflation in your calculation, i.e., part (E) is based on part (D). 2. Use the worst-case, most likely case (or base-case), and best-case NPVs with their probabilities of occurrence, to find the project’s expected NPV, standard deviation, and coefficient of variation. 3. Assume that Allied’s average project has a coefficient of variation (CV) in the range of 1.25 to 1.75. Would the lemon juice project be classified as high risk, average risk, or low risk? What type of risk is being measured here? Hint: calculate CV using results from part (E) then compare with the given range of 1.25 to 1.75.
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
additional $38,000 for shipping and installation. In addition, inventories would rise by $40,000, while
accounts payable would increase by $10,000. All of these costs would be incurred at t = 0. By a special
ruling, the machinery could be depreciated under the MACRS system as 4-year property. The applicable
depreciation rates are 40%, 30%, 20%, and 10%.
The project is expected to operate for 4 years, at which time it will be terminated. The
assumed to begin 1 year after the project is undertaken (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 $45,000.
Unit sales are expected to total 195,000 units per year, and the expected sales price is $1.60 per unit.
Cash operating costs for the project (total operating costs less depreciation) are expected to total 40%
of dollar sales. Allied’s tax rate is 23%, and its WACC is 12%. Tentatively, the lemon juice project is
assumed to be of equal risk to Allied’s other assets.
| PART D | |||||||||||
| Expected inflation | 8% | ||||||||||
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| 0 | 1 | 2 | 3 | 4 | |||||||
| I. Investment Outlays | |||||||||||
| Equipment cost | ($450,000) | ||||||||||
| Installation | (38,000) | ||||||||||
| CAPEX | ($488,000) | ||||||||||
| Increase in inventory | (40,000) | ||||||||||
| Increase in Account Payable | 10,000 | ||||||||||
| ΔNOWC | ($30,000) | ||||||||||
| II. Project Operating Cash Flows | |||||||||||
| Unit sales | 195,000 | 195,000 | 195,000 | 195,000 | |||||||
| Price per unit | $ 1.728 | $ 1.866 | $ 2.015 | $ 2.176 | |||||||
| Total revenues | 336,960 | 363,917 | 392,925 | 424,473 | |||||||
| Operating costs (w/o deprn) | 134,784 | 145,566 | 157,170 | 169,789 | |||||||
| Depreciation | 195,200 | 146,400 | 97,600 | 48,800 | |||||||
| Total costs | $ 329,984 | $ 291,966 | $ 254,770 | $ 218,589 | |||||||
| EBIT (Operating income) | $ 6,976 | $ 71,951 | $ 138,155 | $ 205,884 | |||||||
| Taxes on operating income | 1,604 | 16,549 | 31,776 | 47,353 | |||||||
| EBIT (1 ‒ T) = Aafter tax operating income | $ 5,372 | $ 55,402 | $ 106,379 | $ 158,531 | |||||||
| Add back depreciation | 195,200 | 146,400 | 97,600 | 48,800 | |||||||
| EBIT (1 ‒ T) + DEP | $ 200,572 | $ 201,802 | $ 203,979 | $ 207,331 | |||||||
| III. Terminal Year Cash Flows | |||||||||||
| Salvage value | 45,000 | ||||||||||
| Tax on salvage value | 10,350 | ||||||||||
| After-tax salvage value | 34,650 | ||||||||||
| Recovery of NOWC | 30,000 | ||||||||||
| Project |
($518,000) | $200,572 | $ 201,802 | $ 204,028 | $271,980 | ||||||
| EBIT(1-T) + DEP - CAPEX - ΔNOWC | |||||||||||
Assume that you are confident about the estimates of all the variables that affect the cash flows except
unit sales. If product acceptance is poor, sales would be only 65,000 units a year, while a strong
consumer response would produce sales of 240,000 units. In either case, cash costs would still amount
to 40% of revenues. You believe that there is a 35% chance of poor acceptance, a 15% chance of
excellent acceptance, and a 50% chance of average acceptance (the base case).
1. What is the worst-case
in your calculation, i.e., part (E) is based on part (D).
2. Use the worst-case, most likely case (or base-case), and best-case NPVs with their
probabilities of occurrence, to find the project’s expected NPV, standard deviation, and
coefficient of variation.
3. Assume that Allied’s average project has a coefficient of variation (CV) in the range of 1.25 to 1.75.
Would the lemon juice project be classified as high risk, average risk, or low risk? What type of risk is
being measured here? Hint: calculate CV using results from part (E) then compare with the given range
of 1.25 to 1.75.
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