Question

Amy Cola is considering launching a new soft drink product. The beverage will be sold in a variety of different flavors and will be marketed to young children. In evaluating the proposed project, the company has the following information:

• The company estimates that the project will last for 4 years.

• The company will need to purchase new machinery that has an up-front cost of $40 million (incurred at Year 0). The machinery will be fully depreciated on a 4-year straight-line basis with no salvage value.

• To gain more insight, Indiana had spent $1 million on marketing research costs.

• Production of the new product will take place in a recently vacated facility that the company owns. It is currently empty and Indiana does not intend to lease the facility.

• The project will require a $2 million increase in net operating working capital (NOWC) at Year 0. After Year 0, there will be no changes in NOWC, until Year 4 when the project is completed, and the NOWC is fully recovered.

• The company estimates that sales of the new drink will be $27 million each of the next four years.

• Operating costs (excluding depreciation) are expected to be $11 million each year.

• The company’s tax rate is 20%.

• The owners expect a return of 18% per year but the market interest rate charged by commercial banks are 5% per year.

Based on the information above, the company has estimated the project’s free cash flows as shown in the table below and concluded that it should pursue this business opportunity as it is expected to generate a positive net present value (NPV).

years	0	1	2	3	4
machine investment	(40)
marketing research costs	(1)
net working capital	(2)
revenue		27	27	27	27
costs		(11)	(11)	(11)	(11)
pre-tax profit		16	16	16	16
tax (20%)		(3.2)	(3.2)	(3.2)	(3.2)
free cash flow	(97)	12.8	12.8	12.8	12.8
NPV @5%interest rate	2.39

Discuss whether the company has conducted the analysis correctly and what the flaws are. Revise the cash flow estimation, re-calculate the net present value (NPV), the internal rate of return (IRR), payback period and provide your recommendations.

Answer 1

The company has not conducted the analysis correctly. The problems are :

• $1 million on marketing research costs is a sunk cost. It is already incurred and cannot be recovered. Hence it is irrelevant for cash flow analysis. It should be excluded from the cash flows
• Depreciation is a tax-deductible expense, and should be included in the costs to calculate tax expense. After that, it should be added back to after-tax profit to calculate the free cash flow
• the recovery of NOWC at the end of year 4 should be included in the cash flow for year 4
• The discount rate to use is 18% which is the expected return of owners.

The cash flow estimation, NPV and IRR are calculated as below :

payback period is the time taken for the cumulative FCF to equal the investment. The cumulative FCF exceeds $40 million in year 3. Therefore payback period is between 2 and 3 years.

payback period = 2 + ($40,000,000 - $14,400,000 - $14,400,400) / $14,400,000 = 2.78 years

The project should be rejected as the NPV is negative and the IRR is less than the owners required return