Question

Hawaiian Coconut Milkshakes Inc. (HCM) considers the following project. They would like to expand and add a pineapple branch. The firm has paid $95,000 to a consultant in order to find out more about the available projects and possibilities. The marketing department has done extensive consumer research on the potential demand for the new shakes. The total costs for this research was $275,000. Based on this research, you are now considering opening up a Pineapple Juice division in the firm.

The expected sales for this project are $1,600,000 per year for the next 2 years and $1,400,000 for the final (third) year. Accepting the project would mean that you could use an empty storage unit listed on the balance sheet. This storage unit consists of a very large building, for which you paid $50,000 in 1985. This storage unit has been fully depreciated and has a current market value of $90,000, which is expected to remain stable over time regardless of its use.

Accepting the project would also mean that your current coconut shake sales are affected. In fact, you expect to see your current total after-tax cash flows (not revenues!) from coconut shakes (which are currently $1 million per year) increase immediately (as of t=0) by 14% (i.e., $1,140,000 yearly) because of the attention this project draws and they will continue at this higher level as long as the pineapple project is operational). These changes are predicted to be a direct effect of this new project.

Manufacturing plant and equipment for this project (other than the storage unit) will cost $900,000 and will be depreciated according to a straight-line method over the life of the project. The market value of the manufacturing plant and equipment at the end of the project (t = 3) is $175,000 and is expected to level out at this price. Variable costs are projected at 75% of sales. There are no fixed costs associated with the project. Net working capital requirements are $55,000 at the start, and then respectively 12% and 18% of sales in t = 1, and t = 2. At t = 3 the NWC investments will be recovered. The required rate of return on this project is 18% and the corporate tax rate is 34%.

1) What are the relevant and incremental Operating Cash Flows (OCF) in years t = 0 through t = 3?

2) What are the relevant and incremental cash flows associated with all the long-term assets involved and categorized under Capital Spending in years t = 0 through t = 3?

3) What are the relevant and incremental cash flows associated with changes in Net Working Capital in years t = 0 through t = 3?

4) Your CEO brings up a potentially different scenario for the project and says that the IRS will likely apply 5-year depreciation to the new manufacturing plant and equipment for this project (not the storage unit). What is the effect on the NPV of this project given this new scenario?

5) Also, HCM feels the start of the pineapple project is a good time to eliminate their sales of carbonated high-sugar content beverages, given a rapid market-wide decline in demand for these sugary drinks. Current after-tax cash flows from this sector for HCM is estimated at $800,000 per year, which they plan to cut by an additional 20% each year during the next 5 years, to then quit this sector completely. What effect does this decision have on the NPV of the pineapple project?

6) Finally, HCM considers the use of a $500,000 bank loan to partially finance the pineapple project. The loan terms include a 6% annual interest rate and will be paid off over the next three years. How does this financing choice affect your cash flows?

Answer 1

Operating cash flows

Particular/Years		0 Year	1 Year	2 Year	3 Year
(A) Revenue		0	1600000	1600000	1400000
Less : Variable		0	1200000	1200000	1050000
Opportunity cost		59400	0	0	0
Side Effect		0	-140000	-140000	-140000
Dep.		0	150000	300000	300000
(B) Total			1210000	1360000	1210000
EBIT (A-B)		-59400	390000	-40000	-90000
Less : Tax			132600	-13600	-30600
Net income		-59400	257400	-26400	-59400
OCF		-59400	407400	273600	240600

Addition to net WC

	NWC	Incremental CF
0 Year	55000	25000
1 Year	192000	137000
2 Year	288000	96000
3 Year		-288000

Cash Flows	OCF	Addition to NWC	Net Capital Spending	cash flow from project
0	-59400	25000	900000	-984400
1	407400	137000	0	270400
2	458400	96000	0	362400
3	425400	-288000	-175000	888400