Question

Color Cupcakes wants to expand its business by selling cookies. The following information is used for project evaluation. The new cookies will generate $1,500,000 in sales each year for the next 10 years. A portion of these new sales, $500,000, will come from existing customers who switch from cupcakes to cookies. Because of the expansion, operating expenses will increase by $600,000 per year. The firm spent $200,000 on market research and testing the new recipe. The firm uses straight-line depreciation. The project has an economic life of 10 years. Total cost of the plant, property and equipment that will be required for the project is $1,200,000. The book value will depreciate to 30,000 at project completion. The salvage value is estimated to be $100,000. The firm will increase net operating working capital by $50,000 at the beginning of the project, and it will be liquidated at the end of the project. The firm’s marginal tax rate is 20%. The firm’s bonds have a yield of 8%, its cost of equity is 10%, and its capital structure has 45% debt and 55% equity.

1 What is (are) the irrelevant cash flow(s) in the capital budgeting decision?

2How much is the yearly depreciation expense? Follow the cash flow based approach as discussed in chapter 12. Show calculation steps and/or calculator inputs and highlight your final answer (ignore the dollar sign $

3How much is the initial net cash flow of the project (i.e., CF0)? List the relevant cash flows, show calculation steps and/or calculator inputs, and highlight your final answer (ignore the dollar sign $).

4How much is the project's net operating cash flow in year 7? Show calculation steps and/or calculator inputs and highlight your final answer (ignore the dollar sign $).

5How much is the project's total cash flow in year 10? Show calculation steps and/or calculator inputs and highlight your final answer (ignore the dollar sign $).

6How much is the firm’s WACC? Show calculation steps and/or calculator inputs and highlight your final answer (express in percentage such as 12.34%).

7What is the NPV of this project and what is your investment decision? Show calculation steps and/or calculator inputs and highlight your final answer (keep a whole number).

Answer 1

1. We should not consider market research expenses of $200,000 while arriving at the cashflows because these are sunk costs which are unavoidable though company reject the project

2. Depreciation expenses per year =(cost-book value)/10=(1200000-30000)/10=$117,000

3. Initial cost=Cost of plant, property & equipment +Net working capital=$1200000+50,000=$1,250,000

4 & 5 Mentioned below in the table. Year 7 cash flow:$343,000 and Year10 cash flow:$473,400

6. WACC=(weight of equity*cost of equity)+(weight of debt*after tax cost of debt)

Weight of equity=55%

Weight of debt=45%

Cost of equity=10%

Before tax cost of debt=8%

After tax cost of debt=(befor tax cost of debt*(1-tax rate))=8%*(1-20%)=6.4%

WACC=(55%*10%)+(45%*6.4%)=8.38%

7. NPV can be found using NPV function in EXCEL

=NPV(rate,Year1 to year10 cashflows)-Total cost

=NPV(8.38%,Year1 to Year10 cashflows)-1,250,000

NPV=$1,073,401.07