Question

Aunt Sally’s Sauces Inc., is considering expansion into a new line of all-natural, cholesterol-free, sodium-free, fat-free, low-calorie tomato sauces. Sally has paid $50,000 for a marketing study which indicates that the new product line would have sales of $650,000 per year for the next six years. Manufacturing plant and equipment would cost $500,000, and will be depreciated using the following annual depreciation rates: 0.2, 0.32, 0.1920, 0.1152, 0.1152, 0.0576. The fixed assets will have no market value at the end of six years. Annual fixed costs are projected at $80,000 and variable costs are projected at 60% of sales. Net operating working capital requirements are $75,000 for the six-year life of the project; the outlay for working capital will be recovered at the end of six years. Aunt Sally’s tax rate is 34% and the firm requires a 16% return. a. Compute the annual depreciation and the ending book value of the fixed assets. b. Prepare pro forma income statements for the project for years 1 through 6. c. Compute operating cash flow (NOPAT) for the project for years 1 through 6. d. Compute total projected cash flows for years 0 through 6 for the project. e. Compute the NPV and IRR for the new product line.

Answer 1

a.	Depreciation Rate	Depreciation	Accumulated Depreciation	Ending Book Value
	A	B = A x $500,000	C = B1+B2..Bn	D = 500000 - Accumulated Depreciation
	20.00%	$             100,000	100000	400000
	32.00%	$             160,000	260000	240000
	19.20%	$                96,000	356000	144000
	11.52%	$                57,600	413600	86400
	11.52%	$                57,600	471200	28800
	5.76%	$                28,800	500000	0
	Proforma Income Statement
		Year
b.	Particulars	1	2	3	4	5	6
	Sales	$             650,000	$             650,000	$        650,000	$        650,000	$        650,000	$        650,000
	Less: Variable cost at 60%	390,000	390,000	390,000	390,000	390,000	390,000
	Less: Fixed Cost excluding Depreciation	80,000	80,000	80,000	80,000	80,000	80,000
	Less: Depreciation	$             100,000	$             160,000	$          96,000	$          57,600	$          57,600	$          28,800
	Net operating income	80,000	20,000	84,000	122,400	122,400	151,200
	Less: Tax at 34%	27,200	6,800	28,560	41,616	41,616	51,408
	Net Income	52,800	13,200	55,440	80,784	80,784	99,792
c.	Net Income	52,800	13,200	55,440	80,784	80,784	99,792
	Add Back Depreciation	$             100,000	$             160,000	$          96,000	$          57,600	$          57,600	$          28,800
	NOPAT	$             152,800	$             173,200	$        151,440	$        138,384	$        138,384	$        128,592
d.	Total Projected Cash flows
		Year
		0	1	2	3	4	5	6
	Initial Investment	-500000
	NWC	-75000						75000
	NOPAT		$             152,800	$        173,200	$        151,440	$        138,384	$        138,384	$        128,592
	Total Cash flows	$           (575,000)	$             152,800	$        173,200	$        151,440	$        138,384	$        138,384	$        203,592
	Note: Marketing study cost of $50,000 is sunk cost and irrelevant for capital budgeting decision.
		Year
		0	1	2	3	4	5	6
e.	Total Cash flows	$           (575,000)	$             152,801	$        173,202	$        151,443	$        138,388	$        138,389	$        203,598
	NPV	$            8,349.91
		=-575000+NPV(16%, Value 1 to 6)
	IRR	16.54%
		=IRR(Values 0 to 6)