Question

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:

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?

Answer 1

8. Payback method does not take into account time value of money so considering this, we should consider this investment

9.

NPV is net present value which take into account discounting factor while assessing project's feasibility

IRR is internal rate of return; this is the rate at which NPV is zero

PI is actually measured using payoff received by investment made.          

Since NPV is negative so we should not consider this project

CALCULATIONS

Machine              $    200,000.00                                                   

shipping               $      10,000.00                                                   

installation          $      30,000.00                                                   

4 years of life                                                                    

salvage value     $      25,000.00                                                   

WACC   10%

	Year 0	Year 1	Year 2	Year 3	Year 4
units		1250	1250	1250	1250
cost/unit		$100	$103.00	$106.09	$109.27
SP/unit		$200	$206.00	$212.18	$218.55
Revenue		$250,000	$257,500	$265,225	$273,182
NWC		$30,000.00	$30,900.00	$31,827.00	$32,781.81
	Year 0	Year 1	Year 2	Year 3	Year 4
Investment	$ (240,000)
Revenue		$   250,000.00	$ 257,500.00	$ 265,225.00	$ 273,181.75
cost		$   125,000.00	$ 128,750.00	$ 132,612.50	$ 136,590.88
EBITDA		$   125,000.00	$ 128,750.00	$ 132,612.50	$ 136,590.88
depreciation		$   (43,750.00)	$ (43,750.00)	$ (43,750.00)	$ (43,750.00)
EBIT		$     81,250.00	$    85,000.00	$    88,862.50	$    92,840.88
tax payable		$     32,500.00	$    34,000.00	$    35,545.00	$    37,136.35
Net income		$     48,750.00	$    51,000.00	$    53,317.50	$    55,704.53
FCF		$     62,500	$    63,850	$    65,240	$    66,672.72
discounting factor		0.9090909	0.826446281	0.751314801	0.683013455
DCF	$(240,000)	$     56,818.18	$    52,768.60	$    49,016.15	$    45,538.36

NPV   = ($ 56,818.18 + $52,768.60 + $49,016.15 + $45,538.36) – 240000

NPV = ($35,858.71)