Question

Whole Body Foods is a health food and supplement company. They are considering introducing a new health food product into the market. Along the way, Whole Body Foods has received information from their marketing, finance, engineering, and accounting departments. The following information has been accumulated relating to this project.

• A customer survey was used to determine if this product would have market interest. The cost of the survey was $25,000.
• The project will require the purchase of $900,000 of equipment in 2019 (t = 0)
• Inventory will increase by $175,000 and accounts payable will rise by $75,000. All other working capital components will stay the same, so the net change in net operating working (NWC) is $100,000 at t = 0.
  • The project will last for four years. Each unit will sell for $2 regardless of the year sold. The company forecasts sales for 2020 = $2,685,000. During the following years they expect sales to decline by the following percent of the previous year’s sales:
  • 2021 = - 3.166%
  • 2022 = - 2.885%
  • 2023 = - 2.970%

• The fixed cost of producing the product is $2,000,000 each year, and the variable cost of producing each unit will vary according to the following schedule VC/per unit = $1.018 in 2020, $1.078 in 2021, $1.046 in 2022, and $1.221 in 2023.
• The company will use MACRS using the 3 year schedule of the following percentages (33, 45, 15, 7 % respectively), however the CFO is also interested in seeing how the projects value would change if it instead used the straight line depreciation approach.
• When the project is complete in 2023 (t = 4), the company expects that it will be able to salvage the equipment for $50,000 and that it will fully recover the NWC used in the beginning of the project.
• The estimated tax rate is 40%.
• Based on the perceived risk, the project’s WACC is estimated to be 10%.

Please set up a spreadsheet analysis for this example and calculate the following variables for each choice of depreciation method. Your analysis needs to be completed on a spread sheet. You may answer the questions on the spread sheet as well.

1. NPV and discuss the accept and reject decision for this project.
2. IRR and discuss why we don’t always use this in place of the NPV.
3. Payback and discuss the benefits of using this method as well as the faults.
4. Discounted Payback

MIRR (Modified Internal Rate of Return

Answer 1

Part 1:	Particulars	Amount	Explanation
	Cost of Survey	25,000	Sunk cost and hence should not be considered for analysis

Step 1	Amount
Initial Investment ( 2019)
Cost of equipment	900,000
Working capital	100,000
Total	1,000,000

Step 2
Depreciation	(900000-50000)/4
Straight line	212,500

MACRS Depreciation
Year	Rate	Current Depreciation	Accumulated Depreciation	Book Value
-				900,000
1	0.33330	299,970	299,970	600,030
2	0.44450	400,050	700,020	199,980
3	0.14810	133,290	833,310	66,690
4	0.07410	66,690	900,000	-

Step 3
Working for sales
Year	Percent of decline	Amount of decline	Actual sales	Units
2,020			2,685,000	1,342,500
2,021	0.031660	85,007	2,599,993	1,299,996
2,022	0.028850	75,010	2,524,983	1,262,492
2,023	0.029700	74,992	2,449,991	1,224,996

Variable Costs
Year	Units	Variable cost per unit	Amount
2,020	1,342,500	1.01800	1,366,665
2,021	1,299,996	1.07800	1,401,396
2,022	1,262,492	1.04600	1,320,566
2,023	1,224,996	1.22100	1,495,720

Cash flow schedule - If MACRS method of depreciation is followed
Year	2020	2021	2022	2023
Sales	2,685,000	2,599,993	2,524,983	2,449,991
Less: Variable Cost	1,366,665	1,401,396	1,320,566	1,495,720
Less: Fixed Cost	2,000,000	2,000,000	2,000,000	2,000,000
Less: Depreciation	299,970	400,050	133,290	66,690
Total	(981,635)	(1,201,453)	(928,873)	(1,112,418)
Less: Tax @40%	(392,654)	(480,581)	(371,549)	(444,967)
Cash flow after tax	(588,981)	(720,872)	(557,324)	(667,451)
Add : Depreciation	299,970	400,050	133,290	66,690
Actual Net Cash flow	(289,011)	(320,822)	(424,034)	(600,761)
NPV
Year	Cashflows	DF @10%
2020	(289,011)	0.9900	(286,121)
2021	(320,822)	0.9803	(314,501)
2022	(424,034)	0.9705	(411,524)
2023	(600,761)	0.9608	(577,211)
NWC released	100,000	0.9608	96,080
			(1,493,277)
Less: Initial investment			1,000,000
NPV of project			(2,493,277)

Reject because of negative NPV

If straight line method is followed then by similar method of calculation NPV is -2527916 and hence the same will be rejected.

Here IRR cannot be found out . Because IRR is the rate where cash inflows is equal to cash outflows. But here all are negative cashflows so IRR , payback period caanot be found out and hence in such cases NPV is better