Question

Option #1: Exotic Foods, Inc., Capital Budgeting Case

Exotic Food Inc., a food processing company located in Herndon, VA, is considering adding a new division to produce fresh ginger juice. Following the ongoing TV buzz about significant health benefits derived from ginger consumption, the managers believe this drink will be a hit. However, the CEO questions the profitability of the venture given the high costs involved. To address his concerns, you have been asked to evaluate the project using three capital budgeting techniques (i.e., NPV, IRR and Payback) and present your findings in a report.

CASE OVERVIEW

The main equipment required is a commercial food processor which costs $200,000. The shipping and installation cost of the processor from China is $50,000. The processor will be depreciated under the MACRS system using the applicable depreciation rates are 33%, 45%, 15%, and 7% respectively. Production is estimated to last for three years, and the company will exit the market before intense competition sets in and erodes profits. The market value of the processor is expected to be $100,000 after three years. Net working capital of $2,000 is required at the start, which will be recovered at the end of the project. The juice will be packaged in 20 oz. containers that sell for $3.00 each. The company expects to sell 150,000 units per year; cost of goods sold is expected to total 70% of dollar sales.

Weighted Average Cost of Capital (WACC):

Exotic Food’s common stock is currently listed at $75 per share; new preferred stock sells for $80 per share and pays a dividend of $5.00. Last year, the company paid dividends of $2.00 per share for common stock, which is expected to grow at a constant rate of 10%. The local bank is willing to finance the project at 10.5% annual interest. The company’s marginal tax rate is 35%, and the optimum target capital structure is:

Common equity	50%
Preferred	20%
Debt	30%

Your main task is to compute and evaluate the cash flows using capital budgeting techniques, analyze the results, and present your recommendations whether the company should take on the project.

QUESTIONS

To help in the analysis, answer all the following questions. Present the analysis in one Excel file with the data, computations, formulas, and solutions. It is preferred that the Excel file be embedded inside the WORD document (question 8).

1. What is the total investment amount at the start of the project (i.e., year zero cash flow)?
2. What is the depreciation amount for each year?
   • Create a depreciation schedule
3. What is the after-tax salvage value of the equipment?
4. What is the projected net income and Operating Cash Flows (OCF) for the three years?
   • Complete an income statement for each year.
5. What are the Free Cash Flows (FCF) generated from the project?
   • Create a projected cash flow schedule
6. What is the Weighted Average Cost of Capital (WACC)?
   • Compute the after-tax cost of debt
   • Compute the cost of common equity
   • Compute the cost of preferred stock
   • Compute the Weighted Average Cost of Capital (WACC)
7. Using a WACC of 15%, apply four capital budgeting techniques to evaluate the project, assuming the Free Cash Flows are as follows:

   Years	Free Cash Flows
   0	($252,000.00)
   1	$118,625.00
   2	$127,125.00
   3	$181,000.00

   
   The four techniques are NPV, IRR, MIRR, and discounted Payback. Assume the reinvestment rate to be 8% for the MIRR. Also, assume that the business will only accept projects with a payback period of two and half years or less.
8. Which of the four techniques should be selected and why?

(Show step by step answers )

Answer 1

the Weighted Average Cost of Capital (WACC)

WACC = W_d*C_d+ W_p*C_p+ W_e*C_e

Cost of equity by Gordan model as , P= D / (C_e-g)

=> 75= 2/ (C_e -0.10)

=> C_e = 12.67%

Cost of preference share = D/price = 5/80=6.25%

WACC = 0.30*(10.5%(1-0.35))+0.20*6.25%+0.50* 12.67% = 9.63%

Depreciation table

Depreciation Expense
	Y0	1	2	3	4
Net Capital Costs	-
Depreciation Expense		82,500.00	1,12,500.00	37,500.00	17,500.00
Depreciation - (MACRS)		33.00%	45.00%	15.00%	7.00%
Book value of Machine	250000	1,67,500.00	55,000.00	17,500.00	0
Selling price				100000
Actual benefit(for tax calculation)			100000-17500=	82,500.00
Tax of Selling of Machine			82,500.00*35%=	28,875.00
Net cash flow from machine after tax			100000-28875=		71125

Picture of Excel for Formula and reference

Table of excel for copy

Year	0	1	2	3
Machine cost	-$2,00,000.00
installation cost	-$50,000.00
Total Cost	-$2,50,000.00
New working capital	-$2,000.00
Total cash flow	-$2,52,000.00
Sale revenue		$4,50,000.00	$4,50,000.00	$4,50,000.00
COGS		-$3,15,000.00	-$3,15,000.00	-$3,15,000.00
Gross Profit		$1,35,000.00	$1,35,000.00	$1,35,000.00
Depreciation		-$82,500.00	-$1,12,500.00	-$37,500.00
Cash after Depreciation		$52,500.00	$22,500.00	$97,500.00
Tax		-$18,375.00	-$7,875.00	-$34,125.00
Cash after Tax		$34,125.00	$14,625.00	$63,375.00
Return of Working capital				$2,000.00
Net benefit from selling of machine				$71,125.00
Cash from operation		$34,125.00	$14,625.00	$1,36,500.00
Add Depreciation		$82,500.00	$1,12,500.00	$37,500.00
Free cash flow	-$2,52,000.00	$1,16,625.00	$1,27,125.00	$1,74,000.00	NPV	Pay back
PV(F Cash flow)	-$2,52,000.00	$1,06,380.55	$1,05,772.35	$1,32,056.87	$92,209.77	2 years 3 months 18 days
Pay back Cash flow	-$2,52,000.00	-$1,45,619.45	-$39,847.10	$92,209.77	sum of all	2+(12/132056.872)*39847.1
WACC	9.63%				IRR	MIRR
					27.92%	21.08%
					IRR(B19:E19)	MIRR(B19:E19,9.63%,8%)

Company should take the project as per concept of capital budgeting ,

• NPV>0,
• IRR> WACC
• Payback < required Pay back period.

Which of the four techniques should be selected and why? : data is not sufficient to compare , as only detail of one option is given.