Question

Pastas-R-Us is a frozen food manufacturer owned by Al Dente and his wife Hazel Nutt. Just yesterday they finalized details on a new line of frozen pasta meals to complement their existing line of refrigerated meals. Before deciding to move forward however, they gathered the following information and would like your recommendation on whether to pursue this opportunity. The new frozen line will require $180,000 in new equipment which will be depreciated straight-line to $30,000 over 3 years. It will also require $50,000 for increased working capital which will be returned at the end of the project. Hazel and Al plan to retire and close the business in 3 years. At that time, they expect to sell the existing refrigerated line's equipment for $40,000 and the proposed frozen line's equipment for $30,000. Year 1 sales of the new frozen products is estimated at 40,000 cases @ $12.50/case. Unit sales are projected to grow 5.0% each year thereafter. Production costs are $8.25/case plus an additional $85,000 per year in incremental fixed costs. Year 1 sales of the existing refrigerated products is estimated at 100,000 cases @ $8.75/case. Unit sales are projected to grow 2.5% each year, but if the frozen line is not introduced, there would be no growth in sales. Variable production costs of the refrigerated line are $4.25/case. Based on square footage, the frozen line is allocated an additional $150,000 of existing fixed costs. The company's tax rate is 20% and the required rate of return is 18%. What is the total net income and cash flow for each of the project years? Year 0 Year 1 Year 2 Year 3 Net Income n/a Total Cash Flow What are the results of the following calculations? (Hazel and Al have left instructions that all cash flows in years 1-3 will occur uniformly throughout each year, and that their investment book value includes both fixed assets and working capital.) Payback (# of months) Average Accounting Return (AAR) Net Present Value (NPV) Internal Rate of Return (IRR) Profitablility Index (PI) Which of these capital budgeting tools should you rely on the most in making your recommendation? Payback AAR NPV IRR PI

Answer 1

Incremental EBIT which will occur in the existing refrigerated line if the new frozen line is introduced:

Cash flow table:

For net income and total cash flow, please refer to net income line item and free cash flow line item in the table above.

Valuation table:

Payback period:

NPV should be used to decide whether to invest in the new line or not as it is a more comprehensive criteria for capital investment decisions.