Question

Henry Doyle the president of King’s sugar is evaluating the addition of a new sugar-processing mill, to make white sugar, and eliminate the need to buy white sugar from its competitor, Kennard’s sugar company. King’s sugar makes brown sugar only, but would need a mill to process the brown sugar into white sugar. Kennard’s company produces white sugar from the raw sugar cane. Doyle believes that the new mill will bring in additional revenues and reduce operating costs. The competitor had excess capacity of white sugar that it sells to other sugar mills. Therefore, building the new mill would compete with Kennard’s mill. The new mill will cost $20 million in addition to the working capital requirements. Henry Doyle is wondering whether the investment can be justified. The project is expected to be 6 years until 2025.

The construction of the mill will take two years. $18 million will be spent in 2019, and $2 million in 2020. It is expected that when the plant start operating fully in 2020, the company’s operating costs will be reduced because the savings will be derived from the cost differences of producing versus buying white sugar from Kennard’s mill. The cost savings will be $ 2.8 million in 2020 and $ 3.7 million for the next five years. The company uses 15 % as the cost of capital. The following are the financial projections for the new mill.

2019

2020

2021

2022

2023

2024

2025

Capital Investment

18,000

2,000

0

0

0

0

0

Net working capital (10% of incremental sales)

Sales revenue

6,000

10,600

10,600

10,600

10,600

10,600

10,600

Cost of goods sold (75% sales)

SG&A (5% sales)

Operating savings

2,800

3,700

3,700

3,700

3,700

3,700

Depreciation

2,800

3,400

3,400

3,400

3,400

3,400

3,400

Taxes 40%

Answer all of the questions.

1. What is the net present value (NPV) and internal rate of return (IRR) for the investment?
2. What is the payback period of the project?
3. Would you recommend that King’s sugar go ahead with making this investment? Why?

Answer 1

operating cash flow (OCF) each year = operating savings after tax + depreciation

Project cash flows each year = OCF - capital investment

NPV and IRR are calculated using NPV and IRR functions in Excel

NPV is $538,358

IRR is 16.00%

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = 2 + (cash flow required in year for cumulative cash flows to equal zero / year 3 cash flow) = 2 + ( $4,280,000 / $5,620,000) = 2.76 years

It is recommended to go ahead with this investment as the NPV is positive and IRR is higher than the cost of capital.