Question

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%

What is the projected net income and Operating Cash Flows (OCF) for the three years?

Complete an income statement for each year. What are the Free Cash Flows (FCF) generated from the project? Create a projected cash flow schedule

Answer 1

Weighted Average Cost of Capital Calculation:

Common Stock Price = $ 75, Expected Future Dividend = 2 x 1.1 = $ 2.2, Dividend Growth Rate = 10%

Cost of Equity = ke = [2.2/75] + 0.1 = 0.129333 or 12.933 %

Preferred Stock Price = $ 80 and Preferred Stock Dividend = $ 5

Cost of Preferred Equity = kp = 5 / 80 = 0.0625 or 6.25 %

Bank Interest Rate = R = 10.5 % and Tax Rate = t = 35 %

After-Tax Cost of Debt = kd = (1-t) x R = (1-0.35) x 10.5 = 6.825 %

Target Capital Structure: Debt = D = 0.3, Preferred Equity = P = 0.2 and Common Equity = E = 0.5

Therefore, WACC = 0.3 x 6.825 + 0.2 x 6.25 + 0.5 x 12.933 = 9.764 %

NOTE: Since this is a capital budgeting project in the finance domain (instead of accounting), the project is assumed to be all equity-financed as is the norm. Even though the question says that a bank is willing to finance the project costs, probable interest expenses are ignored in Net Income, OCF and FCF calculations. Further, the Operating Cash Flow (OCF) is calculated as:

OCF = Net Income + Non Cash Changes (Such as Depreciation) - Changes in NWC

Free Cash Flow is given by:

FCF = EBIT(1-Tax Rate) / Taxable Income (in this case) + Depreciation - Changes in NWC - Capital Expenditure.

As the project is assumed to be all equity financed, EBIT(1-Tax Rate) or NOPAT (Net Operating Profit After Tax) should be equal to Net Income. Therefore, FCF = OCF - Capital Expenditure. As this problem does not mention any capital expenditure, the same is assumed to be zero, thereby logically making OCF equal to FCF. However, the presence of an After-Tax Salvage Value alters the context. After-Tax Salvage Value is the cash flow generated by selling the food processor after three years. As this cash flow is not a part of the company's operations, it will not be incorporated in OCF calculation. However, the same will be a part of the firm's FCF and incorporated in it.

NOTE: As the question asks only for the annual Net Income, OCF, and FCF, the same has been provided. I have not calculated the NPV, IRR and Payback Period of the project as the same has not been asked for.