Question

Case: Allied Food Products is considering expanding into the fruit juice business with a new fresh lemon juice product. Assume that you were recently hired as assistant to the director of capital budgeting, and you must evaluate the new project. The lemon juice would be produced in an unused building adjacent to Allied’s Fort Myers plant; Allied owns the building, which is fully depreciated. The required equipment would cost $250,000, plus an additional $30,000 for shipping and installation. In addition, inventories would rise by $20,000, while accounts payable would increase by $6,000. All of these costs would be incurred at t = 0. By a special ruling, the machinery could be depreciated under the MACRS system as 4-year property. The applicable depreciation rates are 45%, 30%, 15%, and 10%. The project is expected to operate for 4 years, at which time it will be terminated. The cash inflows are assumed to begin 1 year after the project is undertaken (t = 1), and to continue out to t = 4. At the end of the project’s life (t = 4), the equipment is expected to have a salvage value of $35,000. Unit sales are expected to total 150,000 units per year, and the expected sales price is $1.50 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 55% of dollar sales. Allied’s tax rate is 21%, and its WACC is 11%. Tentatively, the lemon juice project is assumed to be of equal risk to Allied’s other assets. You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected. To guide you in your analysis, your boss gave you the following set of tasks/questions:

Part (F)

Assume that Allied’s average project has a coefficient of variation (CV) in the range of 1.25 to 1.75. Would the lemon juice project be classified as high risk, average risk, or low risk? What type of risk is being measured here?

Answer 1

NPV=Present value of cash inflows- Present value of cash outflows

Once the firm has arrived at a free cash flow figure, this can be discounted to determine the net present value (NPV). Setting the discount rate isn't always straightforward. Even though many companies use WACC as a proxy for the discount rate, other methods are used as well.

So cashflows end of year

1	=150000*1.5=225000	=100/111=0.900	202500
2	225000	0.811	182475
3	225000	0.731	164475
4	225000	0.658	148050
Salvage value	35000	0.658	23030
			720530

PV of cash inflows $720530

Pv of cash outflows=1*705562-705562

The expected NPV is $14,968 = $15. (Rounded to thousands)

The standard deviation of NPV is $30.3:

Standard deviation ofNPV= [0.25(-$27.8 –$15)2+ 0.50($15 –$15)2+ 0.25($57.8 –$15)2]½= [916]½= $30.3.

So the project's Co efficient of Variation =30.3/15=2

a)The project has a CV of 2.0, which is much higher than the average range of 1.25 to 1.75, so it falls into the high-risk category. The CV measures a project's stand-alone risk—it is merely a measure of the variability of returns.

b)It is reasonable to assume that if the economy is strong and people are buying a lot of lemon juice, then sales would be strong in all of the company's lines, so there would be positive correlation between this project and the rest of the business. However, each line could be more or less successful, so the correlation would be less than +1.0. A reasonable guess might be +0.7, or within a range of +0.5 to +0.9.

If the project's cash flows are likely to be highly correlated with the firm's aggregate cash flows, which is generally a reasonable assumption, then the project would have high corporate risk. However, if the project's cash flows were expected to be totally uncorrelated with the firm's aggregate cash flows, or positively correlated but less than perfectly positively correlated, then accepting the project would reduce the firm's total cost.