Question

Color Cupcakes wants to expand its business by selling cookies. The following information is used for project evaluation.

• The new cookies will generate $1,500,000 in sales each year for the next 10 years. A portion of these new sales, $500,000, will come from existing customers who switch from cupcakes to cookies.
• Because of the expansion, operating expenses will increase by $600,000 per year.
• The firm spent $200,000 on market research and testing the new recipe.
• The firm uses straight-line depreciation. The project has an economic life of 10 years.
• Total cost of the plant, property and equipment that will be required for the project is $1,200,000. The book value will depreciate to 30,000 at project completion. The salvage value is estimated to be $100,000.
• The firm will increase net operating working capital by $50,000 at the beginning of the project, and it will be liquidated at the end of the project.
• The firm’s marginal tax rate is 20%.
• The firm’s bonds have a yield of 8%, its cost of equity is 10%, and its capital structure has 45% debt and 55% equity.
• question 1. What is (are) the irrelevant cash flow(s) in the capital budgeting decision?
• question 2. How much is the yearly depreciation expense? Follow the cash flow based approach as discussed in chapter 12. Show calculation steps and/or calculator inputs and highlight your final answer (ignore the dollar sign $).
• question 3.How much is the initial net cash flow of the project (i.e., CF0)? List the relevant cash flows, show calculation steps and/or calculator inputs, and highlight your final answer (ignore the dollar sign $).
• question 4. How much is the project's net operating cash flow in year 7? Show calculation steps and/or calculator inputs and highlight your final answer (ignore the dollar sign $).
• question 5. How much is the project's total cash flow in year 10? Show calculation steps and/or calculator inputs and highlight your final answer (ignore the dollar sign $).
• question 6. How much is the firm’s WACC? Show calculation steps and/or calculator inputs and highlight your final answer (express in percentage such as 12.34%).
• question 7. What is the NPV of this project and what is your investment decision? Show calculation steps and/or calculator inputs and highlight your final answer (keep a whole number).

Answer 1

1. Irrelevant Cash Flows in Capital Budgeting Decision

Historical costs that are already incurred are not relevant for capital budgeting decisions since they do not have any impact on cash flows.

Therefore the amount of $ 200,000 the firm spent on market research and testing new recipe is not relevant for capital budgeting decisions.

2. Yearly Depreciation Expense

Cost of PPE=$1,200,000

Salvage value for depreciation=$30,000

Life=10 Years

Depreciation Method=Straight Line Method

Depreciation per Year = (Cost-Salvage Value)/Life = (1200000-30000)/10 = $117,000

Tax impact of Depreciation = Depreciation * Marginal Tax Rate = 117000*20% = $ 23,400

3. Initial Cash Outflow of the project(CF0):

Initial Cash Outflow is the cash flow that is occurred at the beginning of the project.

Initial Cash Outflow (CF0) = Cost of Plant Property Equipment + Increase in net operating working capital

= 1,200,000+50,000 = $ 1,250,000

4. Net Operating Cash flow in year 7:

Particulars	Amount	Remarks
Increase in Revenue	1,000,000	The total increase in revenue is 1,500,000 out of which 500,000 is from existing customers switching from cupcakes to cookies. Hence incremental cash flow in sales is 1,000,000 (1,500,000-500,000)
Increase in operating Expense	(600,000)
Depreciation Expense	(117,000)	Depreciation is not a cash expense. Hence it will be added back subsequently. It is considered only to calculate tax expense.
Operating Profit	283,000	(Revenue-Expense-Depreciation)
Tax expense	(56,600)	20% of Profit
Depreciation added back	117,000	Since it is not a cash expense, it is added back
Net cash flow	343,400

5. Total Cash flow in year 10:

In year 10 along with Net operating cash flow, we have cash flow from liquidating working capital and salvaging the machinery.

Cash flow from salvaging machinery:

Book Value = 30,000

Salvage Value = 100,000

Profit = Salvage Value - Book Value = 100,000-30,000=70,000

Tax on profit = 70,000 * 0.2 = 14,000

Cash flow from sale of machinery = Salvage Value - Tax paid = 100,000-14,000 = 86,000

Cash flow from liquidating working capital = 50,000

Therefore total cash flow in year 10 = 343,400 + 50,000 + 86,000 = $ 479,400

6. Calculation of WACC:

WACC = (Equity * Cost of Equity) + (Debt * Cost of Debt) * (1-Tax Rate)

Given Equity = 55% and Debt = 45%

Therefore WACC = 0.55 * 0.1 + 0.45 * 0.08 * (1 - 0.2) = 0.0838 = 8.38%

7. Calculation of NPV and making investment decision:

Net cash flow for year 1 to 9 is same as year 7 since there are no changes in cash flows

Calculation of NPV:

Year	PV Factor @ 8.38%	Net Cash Flow	Present Value of Cash Flow (Net cash flow * PV Factor)
0	1.0000	(1,250,000.00)	(1,250,000.00)
1	0.9227	343,400.00	316,848.13
2	0.8513	343,400.00	292,349.26
3	0.7855	343,400.00	269,744.66
4	0.7248	343,400.00	248,887.85
5	0.6687	343,400.00	229,643.71
6	0.6170	343,400.00	211,887.54
7	0.5693	343,400.00	195,504.28
8	0.5253	343,400.00	180,387.78
9	0.4847	343,400.00	166,440.10
10	0.4472	479,400.00	214,391.01
		NPV	1,076,084.31

Since NPV is positive, we should invest in the project