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Part 1: Capital Budgeting Analysis Adams, Incorporated would like to add a new line of business...

Part 1: Capital Budgeting Analysis Adams, Incorporated would like to add a new line of business to its existing retail business. The new line of business will be the manufacturing and distribution of animal feeds. This is a major capital project. Adams, Incorporated is aware you an in an MBA program and would like you to help analysis the viability of this major business venture based on the following information: • The production line would be set up in an empty lot the company owns. • The machinery’s invoice price would be approximately $200,000, another $10,000 in shipping charges would be required, and it would cost an additional $30,000 to install the equipment. • The machinery has useful life of 4 years, and it is a MACRS 3-year asset. • The machinery is expected to have a salvage value of $25,000 after 4 years of use. • This new line of business will generate incremental sales of 1,250 units per year for 4 years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 3% per year due to inflation. • Net working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 40%, and its overall weighted average cost of capital is 10%. Required:

1. If the company spent $40,000 last year in the upkeep of the empty lot, should this cost be included in the analysis? Why or why not?

2. Disregard the assumptions in part 1 above. What is the machinery’s depreciable basis? What are the annual depreciation expenses?

3. Calculate the annual sales revenues and costs (other than depreciation).

4. Construct annual incremental operating cash flow statements.

5. Estimate the required net working capital for each year based on sales for the following year. Working capital will be recovered at the end of year 4.

6. Calculate the after-tax salvage cash flow.

7. Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR, Profitability Index (PI), and payback?

8. Can you use the Payback method to decide whether this is a good project or not? Why or why not?

9. Interpret what NPV, IRR, and Profitability Index (PI) mean. Based on your interpretation, do these indicators suggest the new business line should be undertaken?

Solutions

Expert Solution

Answer - 1

The cost of upkeeping the empty lot is the fixed cost that Adams, Incorporated used to spend even if the new line of business to its existing retail business is not added, hence this $40,000 should not be included in the Capital Budgeting Analysis.

Answer - 2

The machinery’s depreciable basis is the amount of machinery’s cost that can be depreciated over time.

Machinery’s depreciable basis = Machinery’s invoice price + Shipping charges + Installation cost

Machinery’s depreciable basis = $200,000 + $10,000 + $30,000

Machinery’s depreciable basis = $240,000

Machinery annual depreciation expenses will be calculated on the basis of 3-year MACRS with a useful life of 4 years

Year Working Depreciation expense
1 $240,000 * 33.33% $79,992
2 $240,000 * 44.45% $106,680
3 $240,000 * 14.81% $35,544
4 $240,000 * 7.41% $17,784

Answer - 3

Statement showing annual sales revenues

Year Working Annual Sales
1 1,250 units * $200 $250,000
2 1,250 units * ($200 * 1.03) $257,500
3 1,250 units * ($206 * 1.03) $265,225
4 1,250 units * ($212.18 * 1.03) $273,182

Statement showing annual costs

Year Working Annual Costs
1 1,250 units * $100 $125,000
2 1,250 units * ($100 * 1.03) $128,750
3 1,250 units * ($103 * 1.03) $132,613
4 1,250 units * ($106.09 * 1.03) $136,591

Answer - 4

Statement showing annual operating cash flows

Amount ($)

Particulars Working / Notes Year 1 Year 2 Year 3 Year 4
Incremental Sales Calculated above 250,000 257,500 265,225 273,182
Incremental Cost Calculated above -125,000 -128,750 -132,613 -136,591
Depreciation Calculated above -79,992 -106,680 -35,544 -17,784
Profit before tax 45,008 22,070 97,068 118,807
Tax @ 40% 40% of Profit before tax -18,003 -8,828 -38,827 -47,523
Profit after tax 27,005 13,242 58,241 71,284
Depreciation Add back 79,992 106,680 35,544 17,784
Operating Cash Flow 106,997 119,922 93,785 89,068

Answer - 5

Statement showing net working capital requirement

Amount ($)

Year Working (Sales for following year * 12%) Working Capital Requirement
0 $250,000 * 12% $30,000
1 $257,500 * 12% $30,900
2 $265,225 * 12% $31,827
3 $273,182 * 12% $32,782

Answer - 6

After-tax salvage cash flow = Salvage value of Machinery (1 - Tax Rate)

After-tax salvage cash flow = $25,000 (1 - 0.40)

After-tax salvage cash flow = $15,000

Answer - 7

Statement showing net cash flows

Amount ($)

Particulars Year 0 Year 1 Year 2 Year 3 Year 4
Machine cost -240,000 - - - -
Operating Cash Flow - 106,997 119,922 93,785 89,068
Working Capital Investment -30,000 -30,900 -31,827 -32,782 -
Working Capital Recovered - - - - 125,509
After-tax salvage value - - - - 15,000
Net Cash Flows -270,000 76,097 88,095 61,003 229,577

Statement showing project's NPV

Amount ($)

Year Particulars Amount (A) Discount Factor @ 10% (B) Present Value (A * B)
0 Net cash flows -270,000 1 -270,000
1 Net cash flows 76,097 0.9091 69,179
2 Net cash flows 88,095 0.8264 72,806
3 Net cash flows 61,003 0.7513 45,832
4 Net cash flows 229,577 0.6830 156,804
Net Present Value 74,622

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