Question

ZXY Company is a food product company. ZXY is considering expanding to two new products and a second production facility. The food products are staples with steady demands. The proposed expansion will require an investment of $7,000,000 for equipment with an assumed ten-year life, after which all equipment and other assets can be sold for an estimated $1,000,000. They will be renting the facility. ZXY requires a 12 percent return on investments. You have been asked to recommend whether or not to make the investment.

In preparing and supporting your recommendation to either make the investment or not, include the following items as part of your analysis:

Analysis of financial information.

Identification of risks associated with the investment. Consider:

How risky the project appears.

How far off your estimates of revenues and expenses can be before your decision would change.

The difference if the company were to use a straight line versus a MACRS depreciation.

Recommendation for a course of action.

Explanation of criteria supporting your recommendation

FINANCIAL STATEMENTS

ZXY - Forecast
											Ten Years
Pro-Forma Income Statement	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Total
Brand new Acme System - full system
Income
Revenue
Product A	2,400,000	2,800,000	2,800,000	3,240,000	3,900,000	3,900,000	3,900,000	3,900,000	3,900,000	3,900,000	34,640,000
Product B				900,000	1,350,000	2,500,000	3,000,000	4,000,000	4,950,000	5,500,000	22,200,000
Total · Revenue	2,400,000	2,800,000	2,800,000	4,140,000	5,250,000	6,400,000	6,900,000	7,900,000	8,850,000	9,400,000	56,840,000
Cost of Goods Sold
Pest Control	50,000	66,550	73,205	73,205	73,205	73,205	73,205	73,205	73,205	73,205	702,190
SQF FDA mandates	90,000	90,000	90,000	90,000	90,000	30,000	30,000	30,000	30,000	30,000	600,000
Rent - Plant	400,000	408,000	416,160	424,483	432,973	441,632	450,465	459,474	468,664	478,037	4,379,888
Plant Equip. - Fklf - Scrb/Lease	40,000	64,000	64,000	64,000	64,000	64,000	64,000	64,000	64,000	64,000	616,000
Plant Equip. - Ongoing maintenance	50,000	70,000	75,000	75,000	75,000	75,000	75,000	75,000	75,000	75,000	720,000
Plant Equip. - Parts	40,000	50,000	50,000	50,000	50,000	50,000	50,000	50,000	50,000	50,000	490,000
Miscellaneous - Equipment	15,000	15,000	15,000	15,000	15,000	15,000	15,000	15,000	15,000	15,000	150,000
Building repairs	25,000	25,000	25,000	25,000	25,000	25,000	25,000	25,000	25,000	25,000	250,000
Plant supplies	100,000	120,000	144,000	109,808	120,789	132,868	146,154	160,770	176,847	194,532	1,405,767
Plant Utilities	120,000	210,000	240,000	240,000	240,000	240,000	240,000	240,000	240,000	240,000	2,250,000
Garbage removal/Janitorial	30,000	45,626	52,470	52,470	52,470	52,470	52,470	52,470	52,470	52,470	495,388
Plant telephone	7,200	7,200	7,200	7,200	7,200	7,200	7,200	7,200	7,200	7,200	72,000
Plant payroll expense	495,000	675,000	825,000	885,000	915,000	975,000	1,005,000	1,065,000	1,095,000	1,125,000	9,060,000
Health Benefits	45,360	97,200	105,000	100,000	100,000	100,000	100,000	100,000	100,000	100,000	947,560
WC & P/R Expense	59,400	81,000	99,000	106,200	109,800	117,000	120,600	127,800	131,400	135,000	1,087,200
Installation/Additional Equipment	250,000	-	200,000	-	-	-	-	-	-	-	450,000
Total COGS	1,816,960	2,024,576	2,481,035	2,317,366	2,370,437	2,398,375	2,454,095	2,544,919	2,603,786	2,664,444	23,675,993
Gross Profit	583,040	775,424	318,965	1,822,634	2,879,563	4,001,625	4,445,905	5,355,081	6,246,214	6,735,556	33,164,007
Expenses Other than GOGS
Liability Insurance	60,000	91,253	104,940	104,940	104,940	104,940	104,940	104,940	104,940	104,940	990,776
Bank Service Charges	1,500	1,500	1,500	1,500	1,500	1,500	1,500	1,500	1,500	1,500	15,000
Interest on debt	90,627	187,626	232,323	206,766	166,740	122,959	75,071	31,993	7,539	111	1,121,754
Incentive Plan		13,200	16,500	16,500	16,500	16,500	16,500	16,500	16,500	16,500	145,200
Management	180,000	180,000	180,000	180,000	180,000	190,000	190,000	190,000	190,000	190,000	1,850,000
Workers Comp./P/R Taxes	21,600	21,600	21,600	21,600	21,600	22,800	22,800	22,800	22,800	22,800	222,000
Health Insurance Benefit	4,200	5,082	5,590	5,590	5,590	5,590	5,590	5,590	5,590	5,590	54,004
Office/Administrative Expenses	12,000	15,972	17,569	17,569	17,569	17,569	17,569	17,569	17,569	17,569	168,526
Legal and Professional - Tax	30,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000	120,000
Cellular phones	5,000	5,000	5,000	5,000	5,000	5,000	5,000	5,000	5,000	5,000	50,000
Internet Services	4,400	5,856	6,442	6,442	6,442	6,442	6,442	6,442	6,442	6,442	61,793
Postage & Delivery	1,100	1,464	1,611	1,611	1,611	1,611	1,611	1,611	1,611	1,611	15,448
Office supplies	11,000	9,983	10,981	10,981	10,981	10,981	10,981	10,981	10,981	10,981	108,829
Employee Food & Beverage	1,100	1,464	1,611	1,611	1,611	1,611	1,611	1,611	1,611	1,611	15,448
Local/Business Taxes	1,100	1,464	1,611	1,611	1,611	1,611	1,611	1,611	1,611	1,611	15,448
Property Taxes	12,000	15,000	15,000	15,000	15,000	15,000	15,000	15,000	15,000	15,000	147,000
Travel - Equip. Consultants	25,000	16,500	16,500	16,500	16,500	16,500	16,500	16,500	16,500	16,500	173,500
Licenses and Permits	10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000	100,000
Total Expense	470,627	592,964	658,777	633,220	593,194	560,613	512,725	469,647	445,193	437,765	5,374,724
Net Income before Depreciation	112,413	182,460	(339,812)	1,189,413	2,286,369	3,441,012	3,933,181	4,885,434	5,801,021	6,297,791	27,789,282
Depreciation Expense (	185,770	504,140	652,915	573,415	409,635	325,725	299,025	240,970	124,955	33,450	3,350,000
Tax Expense	-	-	-	-	99,961	934,586	1,090,247	1,393,339	1,702,820	1,879,302	7,100,255
Net Income	(73,357)	(321,680)	(992,727)	615,998	1,776,773	2,180,701	2,543,909	3,251,125	3,973,246	4,385,039	17,339,027
Forecast of Cash Flows
Net Income before Depreciation	112,413	182,460	(339,812)	1,189,413	2,286,369	3,441,012	3,933,181	4,885,434	5,801,021	6,297,791	27,789,282
Deduct startup costs	-	-	-	-	-	-	-	-	-	-	-
Cash flow before income taxes	112,413	182,460	(339,812)	1,189,413	2,286,369	3,441,012	3,933,181	4,885,434	5,801,021	6,297,791	27,789,282
Working Capital	-	-	-	-	-	-	-	-	-	-	-
Lease Payments - Principal	155,146	303,919	401,132	426,689	466,715	510,496	558,384	370,759	149,371	7,389	3,350,001
Pre-Tax Cash Flow	(42,733)	(121,460)	(740,944)	762,725	1,819,654	2,930,516	3,374,796	4,514,674	5,651,651	6,290,402	24,439,282
Taxes	-	-	-	-	99,961	934,586	1,090,247	1,393,339	1,702,820	1,879,302	7,100,255
After tax - Cash Flow	(42,733)	(121,460)	(740,944)	762,725	1,719,693	1,995,930	2,284,549	3,121,335	3,948,831	4,411,100	17,339,027

Answer 1

Calculation of Net Present value of investment proposal:

Under MARCS depreciation
Year	After tax cash flows under MACRS dep.	PV factors @12% pa.	Present value of cash flows
1.00	(42,733.00)	0.89	(38,154.46)
2.00	(121,460.00)	0.80	(96,827.17)
3.00	(740,944.00)	0.71	(527,389.30)
4.00	762,725.00	0.64	484,725.53
5.00	1,719,693.00	0.57	975,799.99
6.00	1,995,930.00	0.51	1,011,200.25
7.00	2,284,549.00	0.45	1,033,413.95
8.00	3,121,335.00	0.40	1,260,654.86
9.00	3,948,831.00	0.36	1,423,988.05
10.00	4,411,100.00	0.32	1,420,256.14
Present value of total cash flows			6,947,667.83
Add: Present value of residual value at the end of year 10 (1000000 x 0.321973)			321,973.24
Present value of total cash inflows from the investment			7,269,641.06
Less: Initial investment			7,000,000.00
Net present value (NPV)			269,641.06

As is clear from the above that the investment in the project would result in significant profit for the company as the NPV of the project is positive, i.e. $269,641.06. Thus, the project is relatively less risky. However, in the initial year the company is expected earn negative cash flows is certainly a matter of concern for the company.   

Recommendation:

Since the NPV of the investment project is $269,641.06 thus, the company should make the investment. Generally, the investors are mainly concerned about the profitability of a project. In this case the net present value of the investment project shows that the project would help the company to earn positive income over the useful life of the project. Thus, the company should make investment in the project.

No investment project is risk free similarly, the project in this case is also not risk free however, and considering that it is expected to have a positive NPV the project is relatively less risky. Hence, the company should invest in the project.

The depreciation method is an important aspect that affects the eventual cash inflow from a project. In case the company uses straight line method of depreciation the annual depreciation would be as following:

Under Straight line method of depreciation
Annual depreciation would have been
Cost investment	7000000
Less: Residual value	1000000
Depreciable value	6000000
Useful life	10 years
Annual depreciation (6000000/10)	600000

  

Since, the annual depreciation under SLM is higher than depreciation in MACRS thus, the project would be even more acceptable as the tax liability would be even lower for the company which in turn would increase the cash inflow to the company. Hence, the investment project should be accepted by the company irrespective of the depreciation method used to ascertain the amount of depreciation.

Decision:

The investment of $7,000,000 should be made as the NPV of the investment project is positive.