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$$s Fort Myers plant; Allied owns the building, which is fully depreciated. The required equipment would cost $$450,000,$ plus an additional $$38,000$ for shipping and installation. In addition, inventories would rise by $$40,000,$ while accounts payable would increase by $$10,000.$ All of these costs would be incurred at t $=0.$ By a special ruling, the machinery could be depreciated under the MACRS system as $4-$year property. The applicable depreciation rates are $40\%,30\%,20\%,$ and $10\%.$

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 $($t $=1),$ and to continue out to t $=4.$ At the end of the project$$s life $($t $=4),$ the equipment is expected to have a salvage value of $$45,000.$

Unit sales are expected to total $195,000$ units per year, and the expected sales price is $$1\mathrm{.}60$ per unit. Cash operating costs for the project $($total operating costs less depreciation$)$ are expected to total $40\%$ of dollar sales. Allied$$s tax rate is $23\%,$ and its WACC is $12\%.$ 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:

Assume that inflation is expected to average $8\%$ over the next $4$ years and that this expectation is reflected in the WACC. Moreover, inflation is expected to increase revenues and variable costs by this same $8\%.$ Does it appear that inflation has been dealt with properly in the initial analysis to this point? If not, what should be done and how would the required adjustment affect the decision?

Allied$$s Lemon Juice Project Considering $8\%$ Inflation

Expected inflation

I. Investment Outlays

Equipment cost

Installation

CAPEX

Increase in inventory

Increase in Account Payable

$\frac{?}{{?}_{\frac{?}{?}}}$ NOWC

II$.$ Project Operating Cash Flows

Unit sales

Price per unit

Total revenues

Operating costs $($w$/$o deprn$)$

Depreciation

Total costs

EBIT $($Operating income$)$

Taxes on operating income

EBIT $(1-T)=$ Aafter tax operating income

Add back depreciation

EBIT $(1-$ T$)+$ DEP

III. Terminal Year Cash Flows

Salvage value

Tax on salvage value

After$-$tax salvage value

Recovery of NOWC

Project Free Cash Flows $=$

EBIT$(1-$T$)+$ DEP $-$ CAPEX $-\frac{?}{{?}_{\frac{?}{?}}}$ NOWC