Assignment Task: Capital Budgeting and Cash Flow Estimation
Allied Food Products is considering expanding into the fruit juice business with a new fresh lemon juice product. Assume that you were recently hired as assistant to the director of capital budgeting, and you must evaluate the new project.
The lemon juice would be produced in an unused building adjacent to Allied's Fort Myers plant; Allied owns the building, which is fully depreciated. The purchase price of the required equipment is $280,000, including shipping and installation costs, and the equipment is eligible for 100% bonus depreciation at the time of purchase. In addition, inventories would rise by $25,000, while accounts payable would increase by $5,000. All of these costs would be incurred at t = 0.
The project is expected to operate for 4 years, at which time it will be terminated. The cash inflows are assumed to begin 1 year after the project is undertaken, or at t = 1, and to continue out to t = 4. At the end of the project's life (t = 4), the equipment is expected to have a salvage value of $25,000.
Unit sales are expected to total 100,000 units per year, and the expected sales price is $2.00 per unit. Cash operating costs for the project are expected to total 60% of dollar sales. Allied's tax rate is 25%, and its WACC is 10%. Tentatively, the lemon juice project is assumed to be of equal risk to Allied's other assets.
You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected. To guide you in your analysis, your boss gave you the following set of tasks/questions:
1. Disregard all the assumptions made in part b and assume there is no alternative use for the building over the next 4 years. Now calculate the project's NPV, IRR, MIRR, and payback. Do these indicators suggest that the project should be accepted? Explain.
2. If this project had been a replacement rather than an expansion project, how would the analysis have changed? Think about the changes that would have to occur in the cash flow table.
3.
a. What three levels, or types, of project risk are normally considered?
b. Which type is most relevant?
c. Which type is easiest to measure?
d. Are the three types of risk generally highly correlated?