Question

Portfolio Project:

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 is the total investment amount at the start of the project (i.e., year zero cash flow)?
2. What is the depreciation amount for each year?
   • Create a depreciation schedule
3. What is the after-tax salvage value of the equipment?
4. What is the projected net income and Operating Cash Flows (OCF) for the three years?
   • Complete an income statement for each year.
5. What are the Free Cash Flows (FCF) generated from the project?
   • Create a projected cash flow schedule
6. 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)
7. 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-	cost of food processor		-200000
	Installation		-50000
	investment in working capital		-2000
	total cash outflow in Year 0		-252000
2-	Year	cost	MACRS rate	Annual depreciation = cost*MACRS rate
	1	250000	33%	82500
	2	250000	45%	112500
	3	250000	15%	37500
	total accumulated depreciation			232500
3-	after tax salvage value of equipment	(selling price -(cost-accumulated depreciation))*(1-tax rate)	(100000-(250000-232500))*(1-.35)	53625
	Year	1	2	3
4-	sales	450000	450000	450000
	cost of sales -70% of sales	315000	315000	315000
	less depreciation	82500	112500	37500
	operating income	52500	22500	97500
	less taxes-35%	18375	7875	34125
	after tax profit	34125	14625	63375
	add depreciation	82500	112500	37500
	operating cash flow	116625	127125	100875
5-	Free cash flow
	Year	0	1	2	3
	total cash outflow in Year 0	-252000
	operating cash flow		116625	127125	100875
	recovery of working capital				2000
	after tax salvage value of equipment				53625
	free cash flow	-252000	116625	127125	156500
6-	WACC
	after tax cost of debt	Interest payment*(1-tax rate)	10.5*(1-.35)	6.825
	cost of preferred stock	preferred dividend/market price	5/80	6.25%
	cost of common stock =( expected dividend/market price)+growth rate	(2.2/75)+10%		12.93%
	expected dividend	current dividend*(1+growth rate)	2*(1.1)	2.2
	WACC
	source	weight	cost	weight*cost
	debt	0.3	6.825	2.0475
	preferred stock	0.2	6.25	1.25
	common stock	0.5	12.93	6.465
	WACC = sum of weight*cost			9.76
7-	Year	free cash flow
	0	-252000
	1	118625
	2	127125
	3	181000
	NPV = Using NPV function in MS excel	NPV(15%,C48:C50)+C47	66287.37569
	IRR = Using IRR function in MS excel	IRR(C47:C50)	29.17%
	MIRR = Using MIRR function in MS excel	MIRR(C47:C50,15%,8%)	21.92%
	Year	free cash flow	present value of cash flow = free cash flow/(1+r)6n r= 15%	present value of cash flow = free cash flow/(1+r)6n r= 15%	cumulative present value of cash flow
	0	-252000	C56/1.15^0	-252000
	1	118625	C57/1.15^1	103152.1739	103152.1739
	2	127125	C58/1.15^2	96124.76371	199276.9376
	3	181000	C59/1.15^3	119010.4381	52723.1
		Discounted payback period = year before final year of recovery+(amount to be recovered/present value of discounted cash flow at final year of recovery)	2+(52723.1/119010.4)	2.44
		Yes project should be accepted as Discounted payback period is less than standard discounted payback period of 2.5 years