Question

F Inc. is a company that operates fast food restaurants and it is considering producing packaged food for sale at grocery stores. The initial investment in production facilities to start this venture will be $ 3 million. The facilities has a three-year life and is depreciated to zero on a straight line basis. The production facilities can be sold for $100,000 at the end of year 3. The variable cost per package is $20, and the fixed cost including salary and renting expense is $810,000 per year.

The F Inc. spent $10,000 to do a market research and found that, at the price of $60 per package, the company will sell 50,000 Packages for the first year. The sales in packages will grow 5% each year. The net working capital is expected to be 10% of revenues, with the investment occurring at the start of each period, where needed. At the end of the project’s life, the Company will recover the net working capital.

The cost of capital for F Inc. is 8%. The marginal tax rate is 40%.

1. Identify operating cash flows each year (show the details of your calculation).

2. Identify total cash flows from assets (CFFA) each year (show the details of cash flows).

3. Estimate the NPV of the investment. Would you suggest to accept the project?(Rounding your answers to two decimal places)

4. What is the operation leverage of this project in year 1 (ignoring taxes)?(Rounding your answers to two decimal places) What are the implications of the operating leverage for evaluating this project?

Answer 1

Year	0	1	2	3
Initial investment	-3000000
Sales Unit		50000	52500	55125
Sale value $60 per pack		3000000	3150000	3307500
Less :Variable cost $ 20		1000000	1050000	1102500
Contribution		2000000	2100000	2205000
Less:Depreciation		966666.7	966666.7	966666.7
Less :Fixed cost(3000000-100000)/3		810000	810000	810000
Operating profit		223333.3	323333.3	428333.3
Less :Tax @ 40%		89333.33	129333.3	171333.3
Profit after tax		134000	194000	257000
Operating cashflow		1100667	1160667	1223667
Add:Salvage value at the end of 3 year				100000
		1100667	1160667	1323667
Net working capital 10% of revenue	-300000	-15000	-15750	330750
Total cashflow	-3300000	1085667	1144917	1654417
PV @ 8%	1	0.925926	0.857339	0.793832
Discounted cash flow	-3300000	1005247	981581.5	1313329
Net present value	157.71

It is not worth investing in this project since the NPV is pretty same as the invested amount

Note

Here the amonut already spent of $ 10000 is sunk cost Any expense that has been incurred already, and cannot be recovered if the project is not taken, is a sunk cost (usually R&D, test market expenses, etc.).Hence irrelevant for calculations

Operation leverage in year -1	(Sales-Variable cost)/profit
	2000000/223333.333
	8.955224

Implication of operating leverage

Operating leverage, in simple terms, is the relationship between fixed and variable costs. Fixed costs are costs that are incurred regardless of the number of units sold. Variable costs change with the level of sales. A company with high operating leverage has a high percentage of fixed costs to total costs, which means more units have to be sold to cover costs. A company with low operating leverage has a high percentage of variable costs to total costs, which means fewer units have to be sold to cover costs. In general, a higher operating leverage leads to lower profits.

The operating leverage here is 8.955% which tells that the project risk is higher which means company needs to sell more products to meet its fixed cost