AAA Health, Inc. (NYSE: A3H) is evaluating a new product, a vitamin C/fish oil blended energy drink. As an assistant director of the capital budgeting division of AAA Health, you are responsible for the evaluation of the proposed project. You collected the following information about the project and the cost of capital. You should make an accept/reject recommendation to the director of your division based on your evaluation. I

Information about the Proposed Project

Initial investment and depreciation: The new drink would be produced in an unused building (owned by AAA Health), which is fully depreciated. The new equipment required for the project would cost $500,000, plus an additional $50,000 for shipping and installation. With the new project, inventories would rise by $60,000, and accounts payable would increase by $10,000. All of these costs would be incurred at t = 0. The machinery will be depreciated under the Modified Accelerated Cost Recovery System (MACRS) as 3-year property. The depreciation rates are 33% at t = 1, 45% at t = 2, 15% at t = 3, and 7% at t = 4.

Project life and salvage value: AAA Health expects to run the project for four years. The cash inflows are assumed to begin one year after the project is undertaken, or at t = 1, and to continue to t = 4. At the end of the projects life (t = 4), the equipment is expected to have a salvage value of $50,000. Also, the firm will recover the net working capital at the end of the project life.

Sales and operating costs: Unit sales are expected to total 50,000 bottles per year, and the expected sale price is $10 per bottle. Cash operating expenses for the project (total operating costs excluding depreciation) are expected to amount to 40 percent of sales revenue.

Tax rate: AAAs marginal tax rate is 30 percent.

Information for the Cost of Capital Estimation

AAA Health has outstanding bonds with a 6% annual coupon rate, 10 years remaining until maturity, and a face value of $1,000. The bonds make semiannual coupon payments and currently are trading in the market at a price of $864.10.

A3H can issue preferred stock with an offering price of $25.00 per share, an annual per-share dividend of $2.40. Flotation costs are equal to 4.0% of the gross proceeds.

Ten-year Treasury bond yield = 5.52%; the market risk premium = 5%; the beta of A3H = 1.6.

Target weight of capital: 40 percent debt, 10 percent preferred stock, and 50 percent common equity.

A3H can undertake a new project without issuing new shares of common stock if the required initial investment does not exceed $600,000. If the initial investment is greater than $600,000, the firm should sell new common stock.

6. Estimate the total amount of the initial investment outlays at t = 0. Hint: Shipping and installation cost and investment in net working capital (= current assets minus current liabilities) should be considered in the initial investment estimation.

7. Calculate annual sales for Year 1 to Year 4.

8. Calculate annual cash operating expenses for Year 1 to Year 4.

9. Calculate annual depreciation amount for Year 1 to Year 4. Hint: The depreciation basis includes the new equipment cost and shipping and installation cost.

10. Estimate annual operating income before taxes for Year 1 to Year 4.

11. Estimate annual operating income after taxes for Year 1 to Year 4.

12. Estimate annual after-tax operating cash flow for Year 1 to Year 4.

13. Calculate the after-tax salvage value of the equipment.

14. Estimate the total terminal year after-tax non-operating cash flow.

15. Estimate the total after-tax cash flow for Year 0 to Year 4