Question

The Scenario:
After recently graduating from KSU, you begin a career as an product investment analyst with Hormel Foods. As the newest Skippy P.B. analyst, your first assignment is to evaluate the following enterprise.

The Skippy P.B. Fruit Bites machine will initially cost $200,000. Hormel expects to use the machine for 10 years. After 10 years, the machine will be worth $20,000 in today’s prices. The machine will be depreciated using straight‐line depreciation over 8 years and the salvage value for depreciation is $5,000.

Hormel is in the 30% tax bracket and the company requires a 10% real after‐tax return on its investments. You expect inflation to be 3%. There is no investment tax credit associated with the machine. You expect maintenance of the machine to cost $4,000 a year and to increase at the general inflation rate.

1. (4 points) Evaluate the interest rate level used in this problem (i.e., is it high, low, acceptable). Justify your answer with an explanation.

2. (16 points) Using the scenario and interest rate information above, prepare a net present cost (NPC) budget for the machine. A NPC budget only includes the items associated with owning the equipment (purchase, terminal value, depreciation, maintenance in this problem). Calculate the after‐tax and pre‐tax capital recovery charges.

3. (26 points) Hormel Foods will use the machine to produce strawberry and grape Skippy P.B. Fruit

Bites. You project selling 160,000 packets of Skippy P.B. Fruit Bites per year at $3.49 (real dollars) per packet in years 1 and 2. You then expect to sell 190,000 packets for $3.49 (real dollars) per packet in years in years 3‐10. The real operating costs are expected to be as follows:

Variable costs (materials, etc) of $20,000/year for years 1‐10;
Ingredient costs of $50,000/year for years 1‐2 and $60,000/year for years 3‐10; Marketing costs of $50,000/year for years 1‐10;
Labor costs of $60,000/year for years 1‐10 expected to increase at 5% per year; Management cost of $80,000/year for years 1‐10 expected to increase at 7% per year.

Prepare a NPV budget for this investment. Use the information provided here in question #3. Also include the Net Present Cost (NPC) for the machine (that you found as your final answer in question #2) as an item (that is as a line item component) in this NPV budget (this cost should be entered as a negative value in this NPV budget).

Answer 1

	a	Interest rate level appears to be high
		10% inflation adjusted return
		Nominal Return (approx) =10+3=13%
		Unless the project is risky, 13% required nominal return appears to be high
		NPC BUDGET
	b	NET PRESENT COST
		Present Value of Cash Flow=(Cash Flow)/((1+i)^N)
		i=diascount rate =10%,
		N=Year of cash flow
	N	Year	0	1	2	3	4	5	6	7	8	9	10
	a	Initial Cost	($200,000)
	b	Salvage Value (After Tax)=20000*(1-0.3)											$14,000
	c	Depreciation tax shield =((200000-5000)/8)*30%		$7,313	$7,313	$7,313	$7,313	$7,313	$7,313	$7,313	$7,313
	d=c/(1.03^N)	Depreciation tax shield at todays dollar		$7,100	$6,893	$6,692	$6,497	$6,308	$6,124	$5,946	$5,773	$0	$0
	e	Maintenance cost(After tax)=4000*(1-0.3)		($2,800)	($2,800)	($2,800)	($2,800)	($2,800)	($2,800)	($2,800)	($2,800)	($2,800)	($2,800)
	f=a+b+d+e	Net Cost at todays price	($200,000)	$4,300	$4,093	$3,892	$3,697	$3,508	$3,324	$3,146	$2,973	-$2,800	$11,200	SUM
	g=f/(1.1^N)	Present Value of Net Annual Cost(at 10% discount)	($200,000)	$3,909	$3,382	$2,924	$2,525	$2,178	$1,876	$1,614	$1,387	-$1,187	$4,318	-$177,074
	NPC	Net Present Cost=Sum of Present Value of cost	-$177,074