Question

"Randy’s" an ice-cream manufacturer is planning to invest in a new product called "strawberry mint ice-cream ", which will include real strawberries. To manufacture the product, Randy’s will have to buy a strawberries processor machine. In addition, since the old ice-cream machine of the company broke down it has to replace it with a new one. Below is the purchasing information about the two machines:

- A strawberries processor machine: The machine costs $500,000 and is depreciated in a straight line over 4 years. This machine has a salvage value of $30,000.

- A new ice-cream machine: The machine costs $850,000 and is depreciated in a straight line over 5 years. This machine has a scrap (salvage) value of $200,000.

Other information:

 The strawberry mint ice-cream project's estimated lifecycle is 5 years.

 Randy’s estimates that in the first year the Product will have revenues of $1 million, and then revenues are expected to increase by 12% annually.

 Production costs are expected to be 60% of the revenues.

 Marketing costs are expected to be 30% of the revenues in the first year and then after 10% of the revenues in the following years.

 At the end of year 5 Randy’s estimates that it will be able to sell the strawberries process machine for $120,000. The ice-cream machine will worth 0 and therefore will not be sold.

 During the last 5 years, Randy’s has spent $20,000 in the development of the strawberry mint ice cream.

 To support the project, Randy’s will need to invest in working capital. The company will need to invest at the beginning of each year in inventory 10% of the expected revenues in the following year, in accounts receivables 25% of the current year’s revenues. Accounts payable will amount to 15% of the cost of goods sold at the beginning of each year. All the working capital will be recovered at the end of the project in 5 years.

 Randy’s corporate tax is 25% and Capital gain tax is 20%.

 Randy’s cost of capital is 13%.

Should Randy’s undertake the project?

Answer 1

Note:- All figures are given as at year end, all inflows and profits are assumed to occur at year end.

Based on the given figures and requirements, the working capital requirements are:-

Year	0	1	2	3	4	5
Inventory Investment (10% of Next to next year Revenue)	$          112,000	$            125,440	$          140,493	$          157,352	$                      -	$                   -
Accounts Receivable (25% of Next year Revenue)	$          250,000	$            280,000	$          313,600	$          351,232	$          393,380	$                   -
Accounts Payable (15% of Next year Production Costs)	$          (90,000)	$          (100,800)	$        (112,896)	$        (126,444)	$        (141,617)	$                   -
Net Working Capital Required	$          272,000	$            304,640	$          341,197	$          382,140	$          251,763	$                   -

Year	0	1	2	3	4	5
Revenue		$         1,000,000	$      1,120,000	$      1,254,400	$      1,404,928	$    1,573,519
Less:- Production Costs (60% of Revenue)		$          (600,000)	$        (672,000)	$        (752,640)	$        (842,957)	$     (944,112)
Less:- Marketing Costs		$          (300,000)	$        (112,000)	$        (125,440)	$        (140,493)	$     (157,352)
Less:- Depreciation (500,000-30,000)/4		$          (117,500)	$        (117,500)	$        (117,500)	$        (117,500)
Net Income before Tax		$            (17,500)	$          218,500	$          258,820	$          303,978	$        472,056
Less:- Corporate Tax @ 25%		$                 4,375	$          (54,625)	$          (64,705)	$          (75,995)	$     (118,014)
Net Income after Tax		$            (13,125)	$          163,875	$          194,115	$          227,984	$        354,042
Add:- Depreciation		$            117,500	$          117,500	$          117,500	$          117,500	$                   -
(A) Net Operating Cash Income		$            104,375	$          281,375	$          311,615	$          345,484	$        354,042
(B) Proceeds from strawberries process machine(net of Tax)						$        102,000
(C) Investment in Working Capital	$       (272,000)	$            (32,640)	$          (36,557)	$          (40,944)	$          130,377	$        251,763
(D) Purchase of Strawberries process machine	$       (500,000)
Total Cash Flows (A+B+C+D)	$       (772,000)	$               71,735	$          244,818	$          270,671	$          475,861	$        707,805
PV Factor @ 13%	1.000	0.885	0.783	0.693	0.613	0.543
PV of Cash Flows	$       (772,000)	$               63,482	$          191,729	$          187,589	$          291,855	$        384,168
Net Present Value	$          346,822

Since the Net Present Value is positive, Randy should undertake this project.

Important Notes:-

1. Tax on Sale of Strawberries process machine = (120,000 - 30,000) * 20% = $18,000 . Hence, sale proceeds net of tax = $120,000 - $18,000 = $102,000

2. All figures except PV factors have been rounded off to whole numbers, alternate approach may be taken by using exact decimals.

3. Old ice-cream machine of the company broke down and had to be replaced in either case even if the Strawberry project was dropped, hence this cost is irreleveant for our project considerations. Similarly Development costs are obsolete and not relevant as these are sunk costs.