Question

Mr. A. and Mr. C. are partners in a local food catering business named BBQ City. Their business currently generates $100,000 per year in sales. They are considering making an investment in a portable BBQ Smoker. The smoker comes in two different models: The Model 100 and the Model 200. Because both models of the BBQ smokers are portable, the catering company will be able to increase the distance they can travel to serve their customers. This means that the company will be able to increase its sales (see below). The company’s tax rate is 35%. The company’s current structure is such that a $1 increase in sales will increase its EBDT by $0.32. The company uses 15% as its required rate of return (cost of capital) for evaluating new projects.

The Model 100 has only half the capacity of the Model 200. Cost to purchase the machines is $13,000 (Model 100) and $22,000 (Model 200). The machines are depreciable under the 5-year MACRS depreciation schedule (see below). The company feels that any potential investment project should be evaluated based on a five year sales forecast.

The expected increase in sales is different, depending on which model is being considered. Because of smaller capacity, the Model 100 will not allow the company to accept catering jobs for groups above a certain size. The expected sales increase for each model is as follows:

Expected Increase in Sales	Year 1	Year 2	Year 3	Year4	Year 5
Model 100	$10,000	$12,000	$15,000	$15,000	$15,000
Model 200	$18,000	$23,000	$25,000	$36,000	$43,000

The investments are mutually exclusive. In other words, the company must choose only one. Which model should the company invest in? Set up the appropriate cash flows for each model. Calculate Payback, IRR, and NPV for each model, based on the above sales forecast. Justify your recommendation, based on your calculation of these numbers. For your reference the MACRS depreciation schedule for a 5 year asset is as follows:

Yr1          .20

Yr2          .32

Yr3          .192

Yr4          .115

Yr5          .115

Yr6          .058

Answer 1

MODEL 100
CASH FLOW
Year	1	2	3	4	5
Increase in sales	10000	12000	15000	15000	15000
Increase in EBDT	3200	3840	4800	4800	4800
Depreciation	2600	4160	2496	1495	1495
EBT	600	-320	2304	3305	3305
Tax	210	0	806.4	1156.75	1156.75
EAT	390	-320	1497.6	2148.25	2148.25
Depreciation	2600	4160	2496	1495	1495
Cash flow	2990	3840	3993.6	3643.25	3643.25
Pv @ 15%	0.869565	0.756144	0.65751623	0.571753	0.49717674
pv of cash flow	2600	2903.592	2625.85683	2083.04	1811.33914
Pv of cash flow	12023.83
NPV=	Pv of cash flow-initial outflow
=	12023.83-13000
=	-976.172
CALCULATION OF PAY BACK PERIOD
	Cash flow	cummulative cf
year0	-13000	-13000
Year 1	2990	-10010
Year 2	3840	-6170
Year 3	3993.6	-2176.4
Year 4	3643.25	1466.85
Year 5	3643.25	5110.1
Earning per day in 4th year=		3643.25/360
	=	10.12014
Days in 4th year to earn 2176.4=			2176.4/10.12014
		=	215.056337
Pay back period=	3 year and 215.0563 days of 4th year
CALCULATION OF IRR
	Cash flow	Pv @ 15%	PV of cash flow at 15%	Pv @ 10%	PV of cash flow at 10%
year0	-13000	1	-13000	1	-13000
Year 1	2990	0.869565	2600	0.909091	2718.18182
Year 2	3840	0.756144	2903.59168	0.826446	3173.55372
Year 3	3993.6	0.657516	2625.85683	0.751315	3000.45079
Year 4	3643.25	0.571753	2083.04001	0.683013	2488.38877
Year 5	3643.25	0.497177	1811.33914	0.620921	2262.17161
Total			-976.17234		642.746708
IRR=	10%+((642.746708/(-976.17234-642.746708)*(15-10)
=	11.985	%
MODEL 200
CASH FLOW
Year	1	2	3	4	5
Increase in sales	18000	23000	25000	36000	43000
Increase in EBDT	5760	7360	8000	11520	13760
Depreciation	4400	7040	4224	2530	2530
EBT	1360	320	3776	8990	11230
Tax	476	112	1321.6	3146.5	3930.5
EAT	884	208	2454.4	5843.5	7299.5
Depreciation	4400	7040	4224	2530	2530
Cash flow	5284	7248	6678.4	8373.5	9829.5
Pv @ 15%	0.869565	0.756144	0.65751623	0.571753	0.49717674
pv of cash flow	4594.783	5480.529	4391.15641	4787.576	4886.99872
Pv of cash flow	24141.04
NPV=	Pv of cash flow-initial outflow
=	24141.043-22000
=	2141.043
CALCULATION OF PAY BACK PERIOD
	Cash flow	cummulative cf
year0	-22000	-22000
Year 1	5284	-16716
Year 2	7248	-9468
Year 3	6678.4	-2789.6
Year 4	8373.5	5583.9
Year 5	9829.5	15413.4
Earning per day in 4th year=		8373.5/360
	=	23.25972
Days in 4th year to earn 2789.6=			2789.6/23.25972
		=	119.932645
Pay back period=	3 year and 119.9326 days of 4th year
CALCULATION OF IRR
	Cash flow	Pv @ 15%	PV of cash flow at 15%	Pv @ 20%	PV of cash flow at 10%
year0	-22000	1	-22000	1	-22000
Year 1	5284	0.869565	4594.78261	0.833333	4403.33333
Year 2	7248	0.756144	5480.5293	0.694444	5033.33333
Year 3	6678.4	0.657516	4391.15641	0.578704	3864.81481
Year 4	8373.5	0.571753	4787.5758	0.482253	4038.14622
Year 5	9829.5	0.497177	4886.99872	0.401878	3950.25559
Total			2141.04284		-710.11671
IRR=	15+((2141.04284/(-710.11671-2141.04284))*(20-15)
=	18.755	%