Universal Agri is considering a proposal to manufacture high-protein hog feed. The project would make use of an existing warehouse, which is currently rented out to a neighbouring firm. The next year's rental charge on the warehouse is $100,000, and thereafter the rent is expected to grow in line with inflation at 4% a year.
In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.2 million. This could be depreciated for tax purposes based on straight-line methods over 10 years. However, Universal Agri expects to terminate the project at the end of 8 years and to dispose of the plant and equipment in year 8 for $400,000. Finally, the project requires an initial investment on working capital of $350,000. Thereafter, working capital is forecast to be 10% of sales in each of years 1 through 8.
Year 1 sales of hog feed are expected to be $4.2 million, and thereafter sales are forecast to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales and profits are subject to tax at 35%. Tax is paid in the same year when profits are earned. The cost of capital is 12%.
(a) You, as a consultant to Universal Agri for the proposed hog feed project, carry out a feasibility study by estimating the Project Cash Flow for each of the years.
(b) What is the Net Present Value of the United Agri's project?
(c) What is the internal return generated by this project?
(d) Recommend whether Univeral Agri should take on this project.