Question

AGOURA MANUFACTURING MINI-CASE

Agoura Manufacturing has announced the introduction of a new product. They forecast product- specific sales demand to last five years. Then because this product is somewhat of a fad, they will terminate the project. Manufacturing of the product will require the acquisition of an existing facility and purchase and installation of some new equipment. The following information describes the new project:

Capital Investment requirement:

Cost of new plant and equipment:      $13,750,000 Shipping and installation costs:                          $   465,000

Working Capital requirements:

An initial working-capital requirement of $350,000 will accompany the start of production. After that, total investment in net working capital during each year will be equal to 16 percent of the dollar value of sales for that year. Therefore, the working capital investment required will increase during years 1 through 3, decrease in year 4, and finally, all working capital is converted to cash at the termination of the project at the end of year 5.

Sales Forecast:

Year	Units Sold
1	75,000
2	115,000
3	195,000
4	75,000
5	45,000

Sales price per unit: $275/unit in years 1–4, $180/unit in year 5 Variable cost per unit: $215/unit

Annual fixed costs: $675,000

Other Assumptions:

Agoura Manufacturing uses the simplified straight-line depreciation method over useful life. The plant and equipment will have no salvage value after five years. Agoura Manufacturing pays taxes at a 34% marginal rate. Their cost of capital is 17%, and this project offers a similar risk profile to the company’s overall operations.

1.Calculate its internal rate of return?

Answer 1

ANSWER :

WORKING NOTES

1. In Capital Invest ment it states that "acquisition of existing facility and purchase and Installation of some New machinery". But the cost of acquisition is not given. Only the price of the new machinery and the installation costs are given.                        

    1. Capital Investment :

          Cost of New plant                                                  $13,750,000

         Shipping and Installation                                         $    465,000

                             TOTAL                                             $ 14,215,00

       Useful life                                         5 years

      Salvage value                                    NIL

      Depreciation under SLM   =   (Asset cost - Salvage value ) / Useful life

                                                = ( 14,215,000 - Zero)/5

                                                 = 28,43,000   per year

2. calculation of yearly sales value & working capital

   Year             Units Sold       Selling price /    Sales Value Variable cost/     Total Variable cost

                                                 Unit                                       unit

     1               75,000                  275            20,625,000                  215                     16,125,000

     2           1,15,000                  275             31,625,000                  215                      24,725,000

3    1,95,000    275    53,625,000 215 41,925,000

4.    75,000    275    20,625,000 215 16.125,000

5.    45,000    180    8,100,000    215    9,675,000

              -----------------------------------------------------------------------------------------------------------------------------------

Total      505,000                                   320,225,000                                            108,575,000

            ====================================================================

3. Working Capital required in each year . This in the First year is assumed to be in addition to the initial working capital required $ 350,000 . @ 16 % of the sales value of in $ terms.

Year                                          Working Capital

0                                                  350,000

1                                              3,300,000

2                                               5,060,000

3                                               8,580,000

4.                                               3,300,000

5                                                1,296,000

                                             ----------------------

Total                                    21,886,000

                                          =============

4. Annual Fixed Cost = $ 675,000

So total Fixed cost    = 675,000 *5 = $ 3,375,000

6. Cost of Capital @ 17 % on the Amount Invested in First year :

= (14,215,000 + 350,000) = 14,565,000 * 16/100 = 2,330,400 per year

                      Total for 5 years = 2,330,400 * 5       = 11,652,000

7.Tax Rate @ 34 %

8.    Calculation of Net Cash Flow as a whole for the 5 years

Sales Revenue    320,225,000

Less :

1. Fixed Expenses    3,375,000

2. Variable Costs 108,575,000

   3. Depreciation    14,215,000

   4. Cost of Capital 11,652,000                           137,817,000

   -------------------------------------------------------------------                     Profit before Tax    182,408,000

Tax @ 34 % for 5 years 62,018,720

-----------------------------

            Net Receipts                                                                120,389,280

Add Back Depreciation                                                             14,215,000

                                                                                           -------------------------

                                    Net cash flow 134,604,280

                                                                                            ============

9. INTERNAL RATE OF RETURN   = CASH FLOWS /(1 +r)^i - iNVESTMENT

                                                   = ( 134,604,280 + 9675,000)/ (1 +r)^5 - INVESTMENT

   Internal Rate of return is a discounted rate that makes the NPV ,net present value of all cash flows from a particular project equals ZERO