Question

Exotic Food Inc., Capital Budgeting Case

CASE SUMMARY

Exotic Food Inc., a food processing company located in Herndon, VA, is considering adding a new division to produce fresh ginger juice. Following the ongoing TV buzz about significant health benefits derived from ginger consumption, the managers believe this drink will be a hit. However, the CEO questions the profitability of the venture given the high costs involved. To address his concerns, you have been asked to evaluate the project using three capital budgeting techniques (i.e., NPV, IRR and Payback) and present your findings in a report.

CASE OVERVIEW

The main equipment required is a commercial food processor which costs $200,000. The shipping and installation cost of the processor from China is $50,000. The processor will be depreciated under the MACRS system using the applicable depreciation rates are 33%, 45%, 15%, and 7% respectively. Production is estimated to last for three years, and the company will exit the market before intense competition sets in and erodes profits. The market value of the processor is expected to be $100,000 after three years. Net working capital of $2,000 is required at the start, which will be recovered at the end of the project. The juice will be packaged in 20 oz. containers that sell for $3.00 each. The company expects to sell 150,000 units per year; cost of goods sold is expected to total 70% of dollar sales.

               Weighted Average Cost of Capital (WACC):

Exotic Food’s common stock is currently listed at $75 per share; new preferred stock sells for $80 per share and pays a dividend of $5.00. Last year, the company paid dividends of $2.00 per share for common stock, which is expected to grow at a constant rate of 10%. The local bank is willing to finance the project at 10.5% annual interest. The company’s marginal tax rate is 35%, and the optimum target capital structure is:

Common equity	50%
Preferred	20%
Debt	30%

Your main task is to compute and evaluate the cash flows using capital budgeting techniques, analyze the results, and present your recommendations whether the company should take on the project.

QUESTIONS

To help in the analysis, answer all the following questions. Present the analysis in one Excel file with the data, computations, formulas, and solutions. It is preferred that the Excel file be embedded inside the WORD document (question 8).

1. What are the Free Cash Flows (FCF) generated from the project?
   • Create a projected cash flow schedule
2. What is the Weighted Average Cost of Capital (WACC)?
   • Compute the after-tax cost of debt
   • Compute the cost of common equity
   • Compute the cost of preferred stock
   • Compute the Weighted Average Cost of Capital (WACC)
3. Using a WACC of 15%, apply four capital budgeting techniques to evaluate the project, assuming the Free Cash Flows are as follows:

Years	Free Cash Flows
0	$ -252,000.00
1	$118,625.00
2	$127,125.00
3	$181,000.00

The four techniques are NPV, IRR, MIRR, and discounted Payback. Assume the reinvestment rate to be 8% for the MIRR. Also, assume that the business will only accept projects with a payback period of two and half years or less.

Answer 1

1)		0	1	2	3
	Sales		$   4,50,000.00	$    4,50,000.00	$    4,50,000.00
	Variable cost		$   3,15,000.00	$    3,15,000.00	$    3,15,000.00
	Depreciation		$       82,500.00	$    1,12,500.00	$       37,500.00	17500.00
	NOI		$       52,500.00	$        22,500.00	$       97,500.00
	Tax at 35%		$       18,375.00	$          7,875.00	$       34,125.00
	Incremental NOPAT		$       34,125.00	$        14,625.00	$       63,375.00
	Add: Depreciation		$       82,500.00	$    1,12,500.00	$       37,500.00
	Incremental OCF		$   1,16,625.00	$    1,27,125.00	$    1,00,875.00
	Capital expenditure	$      2,50,000.00
	After tax salvage value = 100000-(100000-17500)*35% =				$       71,125.00
	Change in NWC	$            2,000.00			$          2,000.00
	FCF of the project	$    -2,52,000.00	$   1,16,625.00	$    1,27,125.00	$    1,74,000.00
2)	After tax cost of debt = 10.5%*(1-35%) =	6.83%
	Cost of common equity = 2*1.1/75+0.10 =	12.93%
	Cost of preferred stock = 5/80 =	6.25%
	WACC = 12.93%*50%+6.83%*30%+6.25%*20% =	9.76%
3)		0	1	2	3
a)	FCF	$    -2,52,000.00	$   1,18,625.00	$    1,27,125.00	$    1,81,000.00
	PVIF at 15% [PVIF = 1/1.15^n]	1	0.86957	0.75614	0.65752
	PV at 15%	$    -2,52,000.00	$   1,03,152.17	$        96,124.76	$    1,19,010.44
	NPV	$         66,287.38
b)	PI = 318287.38/252000 =	1.26
c)	IRR:
	IRR is that discount rate for which NPV = 0. Such discount rate is to be found out by trial and error.
	Discounting with 30%:					NPV
	FCF	$    -2,52,000.00	$   1,18,625.00	$    1,27,125.00	$    1,81,000.00
	PVIF at 30% [PVIF = 1/1.30^n]	1	0.76923	0.59172	0.45517
	PV at 30%	$    -2,52,000.00	$       91,250.00	$        75,221.89	$       82,385.07	$      -3,143.04
	Discounting with 29%:
	FCF	$    -2,52,000.00	$   1,18,625.00	$    1,27,125.00	$    1,81,000.00
	PVIF at 30% [PVIF = 1/1.30^n]	1	0.77519	0.60093	0.46583
	PV at 30%	$    -2,52,000.00	$       91,957.36	$        76,392.64	$       84,315.89	$            665.90
	IRR = 30%+1%*665.90/(665.90+3143.04) =	30.17%
d)	FCF	$    -2,52,000.00	$   1,18,625.00	$    1,27,125.00	$    1,81,000.00
	FVIF at 8% (FVIF = 1.08^n)		1.16640	1.08000	1.00000
	FV at 8%		$   1,38,364.20	$    1,37,295.00	$    1,81,000.00	$ 4,56,659.20
	MIRR = (456659.20/252000)^(1/3) =	21.92%
e)	Cumulative discounted PVs	$    -2,52,000.00	$ -1,48,847.83	$      -52,723.06	$       66,287.38
	Discounted payback = 2+52723/119010.44 =	2.44