Capital Budgeting: Analyzing Project Cash Flows (Alexandria Chemical Products Company)
In early 1980s Alexandria Chemical Products started as a small firm between two friends to produce detergent products. By the end of 1997 the company became a shareholders corporation. Now it is a leading company in the chemical industry.
On July 20, 2011, Mr. Amro, the president of the company met with Mr. Ahmed, vice-president in charge of new product; Mr. Ali, the financial directors; and Dr. Sultan, the R&D director. The purpose of the meeting was to discuss and the capital budgeting decision with regarded the production of a new product. Mr. Amro gave a brief statement about the purpose of the meeting, and immediately gave the floor to Mr. Ahmed.
Mr. Ahmed started his presentation about the new product by providing information about this product, the relationship between the new product and the current products portfolio, as well as the competitive position of the company and the effect of the new products on this competitive position. Mr. Ahmed said that: "the new product requires a new production line which costs $8.5 million; useful life 10 years end with $0.5 million as salvage value." He added that "the new production line will increase cash because it will reduce the payables account by $0.5 million. On the another hand it generates $28.9 million during its useful life while it costs $8.5 million which means $20.4 million net cash. Therefore, I recommend to buy this production line because the new product will add value to the shareholders' wealth. To keep this clear he passed out copies of the projection annual cash flow of this project (table 1).
Mr. Amro thanked Mr. Ahmed and gave the floor to Mr. All who critiqued the approach used by Mr. Ahmed to analyze the project initial investment and the annual cost flow. In addition Mr. Ali said "the method of evaluating this project is not a scientific method." Mr. Ali proposed to use the NPV to evaluate this production line, where the hurdle rate is 18%.
Table 1 - New Product annual cash flow (million dollars)
|
Year
|
1
|
2
|
3
|
4
|
5
|
6
|
7
|
8
|
9
|
10
|
|
Sales
|
3.5
|
4.8
|
6.2
|
9.5
|
16.8
|
18.0
|
15.0
|
12.5
|
9.6
|
6.0
|
|
- COGS
|
2.1
|
2.9
|
3.7
|
5.7
|
10.1
|
10.8
|
9.0
|
7.5
|
5.8
|
3.6
|
|
GOI
|
1.4
|
1.9
|
2.5
|
3.8
|
6.7
|
7.2
|
6.0
|
5.0
|
3.8
|
2.4
|
|
- Annual Depreciation
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
|
NOI
|
0.6
|
1.1
|
1.7
|
3.0
|
5.9
|
6.4
|
5.2
|
4.2
|
3.0
|
1.6
|
|
- Interest
|
0.48
|
0.48
|
0.48
|
0.48
|
0.48
|
0.48
|
0.48
|
0.48
|
0.48
|
0.48
|
|
EBT
|
0.1
|
0.6
|
1.2
|
2.5
|
5.4
|
5.9
|
4.7
|
3.7
|
2.6
|
1.1
|
|
- Taxes (25%)
|
0.03
|
0.16
|
0.30
|
0.63
|
1.36
|
1.48
|
1.18
|
0.93
|
0.64
|
0.28
|
|
NI
|
0.1
|
0.5
|
0.9
|
1.9
|
4.1
|
4.4
|
3.5
|
2.8
|
1.9
|
0.8
|
|
+ Annual Depreciation
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
0.8
|
|
Annual Cash Flow
|
0.9
|
1.3
|
1.7
|
2.7
|
4.9
|
5.2
|
4.3
|
3.6
|
2.7
|
1.6
|
1. If you were Mr. Ali, the financial director, what are the mistakes Mr. Ahmed did when he analyzed the project cash flow?
2. Calculate the initial investment and the annual cash flow.
3. Calculate the NPV for this capital budgeting project.
4. According to NPV, Should the company buy this production line?