5 Allied Food Products is considering expanding into the fruit juice business with a new fresh 6 lemon juice product. Assume that you were recently hired as assistant to the director of capital 7 budgeting and you must evaluate the new project. 3 9 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 1 is $600,000, including shipping and installation costs, and the equipment is not eligible for 100% bonus 2 depreciation at the time of purchase. Depreciation will be calculated using the straight-line method over 3 the economic life of the project. In addition, inventories would rise by $15,000, accounts receivable by 4 $25,000, while accounts payable would increase by $10,000. All of these costs would be incurred at t = 0. 5 6 The project is expected to operate for 5 years, at which time it will be terminated. The cash 7 inflows are assumed to begin 1 year after the project is undertaken, or at t = 1, and to continue 3 out to t = 5. At the end of the project's life (t = 5), the equipment is expected to have a salvage 3 value of $30,000. 3 1 Unit sales are expected to total 200,000 units per year, and the expected sales price is $2.80 per 2 unit. Cash operating costs for the project are expected to total 70% of dollar sales. Allied's tax rate 3 is 30%, and its WACC is 9%. Tentatively, the lemon juice project is assumed to be of equal risk to 4 Allied's other assets. Inflation of 2% will impact the sales price and operating costs, beginning in year 1. 5 6 You have been asked to evaluate the project and to make a recommendation as to whether it 7 should be accepted or rejected. To guide you in your analysis, your boss gave you the following 3 set of tasks/questions. 5 $600,000 $114,000 Use straight-line depreciation over the life of the project $30,000 570000 114000 INPUT DATA 1 Project life 2 3 Initial Costs Equipment 5 Depreciation/Year Expected salvage value 7 Changes in NOWC 3 Accounts receivable Inventories Accounts payable 1 2 Expected unit sales 3 Price per unit 1 Oper. costs (% of sales) 5 5 Tax rate 7 WACC 3 Inflation Rate $25,000 $15,000 $10,000 200,000 $2.80 70.0% 30.0% 9.0% 2.0% 07 c. Assume that you are confident about the estimates of all the variables that affect the cash flows 08 except unit sales. If product acceptance is poor, sales will be only 150,000 units a year, while 09 a strong consumer response will produce sales of 250,000 units. In either case, cash costs 10 will still amount to 70% of revenues. You believe that there is a 25% chance of poor acceptance, 11 a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case). 12 13 (1) What is the worst-case NPV? The best-case NPV? 14 15 We used this spreadsheet model to develop these scenarios: 16 17 Case Probability NPV 18 Worst 25% Base 50% Best 25% 21 22 (2) Use the worst-case, most likely case (or base-case), and best-case NPVs with their probabilities of occurrence to find the project's expected NPV, standard 24 deviation, and coefficient of variation. 25 26 Expected NPV $27,134 27 Standard deviation $85,553 28 Coefficient of variation 29 19 20 23