Question
Amy Cola is considering launching a new soft drink product. The beverage will be sold in a variety of different flavors and will be marketed
Amy Cola is considering launching a new soft drink product. The beverage will be sold in a variety of different flavors and will be marketed to young adult. In evaluating the proposed project, the company has the following information:
The project is estimated to last for 4 years and will have a debt ratio for 25%.
The company will need to purchase new machinery that has an up-front cost of $94 million (incurred at Year 0). The machinery will be fully depreciated on a 4-year straight-line basis with no salvage value.
To gain more insight, Amy Cola had spent $2 million on marketing research costs.
Production of the new product will take place in a vacated facility that the company owns. It is currently empty and Amy Cola does not intend to lease the facility.
The project will require a $15 million increase in net operating working capital (NOWC) at Year 0. After Year 0, there will be no changes in NOWC, until Year 4 when the project is completed, and the NOWC is fully recovered.
The company estimates that sales of the new drink will be $78 million each of the next four years.
Operating costs (excluding depreciation) are expected to be $36 million each year.
The companys tax rate is 20%.
The owners expect a return of 15% per year and the interest rate charged by commercial banks is 10% per year.
Based on the information above, the company has estimated the projects free cash flows as shown in the table below and concluded that it should not pursue this business opportunity as it is expected to generate a negative net present value (NPV). Discuss whether the company has conducted the analysis correctly and what the flaws are. Revise the cash flow estimation, re-calculate the net present value (NPV), the internal rate of return (IRR), payback period and provide your recommendations.
| Year | 0 | 1 | 2 | 3 | 4 |
| Machine investment | (94) |
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| Marketing research cost | (2) |
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| Net working capital | (15) |
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| Revenue |
| 78 | 78 | 78 | 78 |
| Costs |
| (36) | (36) | (36) | (36) |
| Pre-tax profit |
| 42 | 42 | 42 | 42 |
| Tax (20%) |
| (8.4) | (8.4) | (8.4) | (8.4) |
| Free cash flow | (111) | 33.6 | 33.6 | 33.6 | 33.6 |
| NPV@15% | (15.07) |
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Income Tax Fundamentals 2013
Authors: Gerald E. Whittenburg, Martha Altus Buller, Steven L Gill
31st Edition
1111972516, 978-1285586618, 1285586611, 978-1285613109, 978-1111972516
