Question

Fruit-To-Go (FTG) processes fruit for shipping overseas. FTG commissioned a study to look into the feasibility of changing the packaging of the fruit from cans to sealed bags. The Consultant charged $54,000 for the report. The report concluded that the new packaging will increase sales and reduce some operating costs. The new packaging machinery will cost $1,100,000. The new machine is expected to last 5 years. The Taxation Office advise the life of the machine, for tax purposes, is 4 years. The old canning machinery was purchased 2 years ago for $800,000 and was being depreciated at $200,000 and will be for the next 2 years. The old machine could be sold today for $260,000. In 5 years it will be worth nothing. Installing the new machine will require staff training (a tax deductible expense) of $35,000 before production can commence. Due to the lower cost of the bags Inventory required will be reduced by $80,000 for the life of the project. The new sales of bagged fruit is expected to be $700,000 in Year 1 rising by 15% for 2 years then 0% for the rest of the life of the project. Variable Costs associated with the new packaged fruit are 50% of sales. Canned fruit production will be discontinued. Sales of canned fruit were static at $450,000 with variable costs of $225,000 (50% of Sales). The new equipment is very hi-tech. Maintenance costs are expected to be higher at $44,000 per year. Maintenance costs on the old machine were $30,000 per year. The lighter packaging will reduce annual freight cost significantly from $250,000 to $100,000 per year. Fixed costs are expected to remain at $320,000 per year. At the end of the project the new machinery can be sold for $275,000. Notes: FTG will borrow the full Year 0 funds using a secured five-year interest-only loan at an interest rate of 10% per annum to finance the new equipment. The company tax rate is 30%. The required rate of return is 12.5%.

Requirements:

1- The IRR of the project

2- The PI of the project

3- The payback of the project

4- A brief recommendation

Answer 1

Capital Investment decision is based on the incremental cash flows from the proposed project.For obtaining incremental cash flows, we will compute the incremental capex, incremental sales, variable costs, freight costs, maintenance costs, and depreciation.

Cost of new machine	1,100,000.00
Selling price of old machine	260,000.00
Staff training cost	35,000.00
Incremental Capex	875,000.00
Initial Investment	1,135,000.00
Salvage Value	275,000.00
Depreciation expense per year	215,000.00

The appropriate discount rate is the opportunity cost of the capital for a similar risky project. It is given as:Required rate of return=12.5%

	1	2	3	4	5
New machine sales	700000	805000	925750	925750	925750
Old machine sales	450000	450000	450000	450000	450000
Incremental Sales	250000	355000	475750	475750	475750
New machine Variable Costs	350000	402500	462875	462875	462875
Old machine Variable Costs	225000	225000	225000	225000	225000
Incremental Variable Costs	125000	177500	237875	237875	237875
New machine maintenance cost	44000	44000	44000	44000	44000
Old machine maintenance cost	30000	30000	30000	30000	30000
Incremental maintenance cost	14000	14000	14000	14000	14000
New machine freight cost	100000	100000	100000	100000	100000
Old machine freight cost	250000	250000	250000	250000	250000
Incremental freight cost	-150000	-150000	-150000	-150000	-150000
New machine depreciation	215000	215000	215000	215000	0
Old machine depreciation	200000	200000	0	0	0
Incremental depreciation	15000	15000	215000	215000	0

1 - IRR of the project is 19.93%

2.PI of the project is 1.227

3.The payback period as suggested by Taxation office is 4 years

4.The project should be accepted as the NPV is positive, IRR>Required rate of return and PI>1.