Capital Budgeting Analysis

Narang Inc. is a producer of ethnic citrus drinks in the U.S. They produce innovative, fresh, fruit drinks based on ethnic recipes from across the world. Narang buys fresh fruit in the global commodities markets and bottles their recipes in the U.S. Their main target is the ethnic population in the U.S., and they distribute their products through international food markets all over the country. Recently, they have ventured into the market for sugarcane juices, and are looking to produce a new juice, Cane Zinger. The juice borrows from an Indian recipe, and is a blend of sugarcane juice, ginger, and mint, mixed in with a hint of cayenne.

Production facilities for Cane Zinger would be set up in an unused section of Narangs main plant. Currently, this space is being leased by another production firm for one of their products. If Narang uses the space for Cane Zinger, the firm will forego lease income to the tune of

$60,000 per year. Two years ago, Narang spent $350,000 to rehabilitate the facility.

Machinery and other equipment needed to set up the production line are estimated to cost

$600,000 with an additional $35,000 for shipping and handling. Inventory (raw materials, work- in-process, and finished products) would have to be increased by $30,000 at the time of the initial investment, and in addition, a recurring increase of $2,500 will be needed each year of the projects operation. All of this is expected to be recovered at the completion of the project. The machinery will be depreciated under the MACRS 3-year class. The machinery is expected to have a salvage value of $75,800 after 5 years of use.

Narangs marketing department has estimated a demand of 250,000 16-ounce cans of Cane Zinger each year in the next 5 years. The price is expected to be $4.50 per can. Fixed costs are estimated to be $200,000 per year, and variable operating costs are expected to be $2.30 per can. Narang expects Cane Zinger to be popular enough to cut into their sales of some of their already existing products. They estimate that the cannibalization will reduce existing product sales by about $150,000 net per year. Prior to production, test marketing of Cane Zinger cost $242,000. Narang is in the 21% tax bracket, and its overall WACC is 9%.

Your task is to complete a report in which you determine whether Narang should invest in the Cane Zinger project or not. You should investigate several inflation scenarios that are possible:

(1) A base case where no inflation assumptions are made.

(2) When inflation in sales price is expected to be 4% and variable cost to be 3% beyond year 1.

(3) When inflation is 4% in both sales price and variable cost beyond year 1. Use the questions below to analyze and structure your report.

Questions:

1. Using the base case assumptions, set out the initial investment outlay for the project in Year 0, as well as the annual operating cash flows in each year of the project. Justify what items have to be included in estimating the free cash flows to the firm from the project, and what items can be ignored. Should the project be undertaken?