Question

VGY Foods is a local company that makes instant noodles. Last year, the company spent $196,000 hiring a marketing consultant to evaluate whether or not a line of phat mama (stir-fried instant noodles) should be launched. The consultant finds that the new product will be able to generate $168,000 of additional sales revenue per year for the company. Production of the new product will involve the following activities:

- A new machine has to be purchased prior to commencement of production. The new machine will cost $5,120,000 and has a useful life of four years. For tax purposes, assume the new machine would be fully depreciated by the straight-line method over a period of 8 years.

- If the company accepts this project, the annual cash expenses of the company will decrease from $6,880,000 to $6,220,000.

- The project will necessitate an increase in inventory of $1,480,000.

- To purchase the new machine, it appears that the company has to borrow $4,000,000 at 10% interest from its bank, resulting in additional interest expenses of $200,000 per year.

In addition, the marginal tax rate and the required rate of return for the company are 42% and 30% respectively. As a finance manager of the firm, you are required to evaluate this project.

a. Determine the initial outlay associated with this project.  

b. Calculate the annual after-tax cash flows associated with this project, for years 1, 2, 3 and 4.  

c. Discuss whether you would accept or reject the project if the required payback period is three years.

d. Would your decision be different if the internal rate of return rule is employed?

e. What would be your decision if the net present value rule is used?

Answer 1