CAPITAL BUDGETING AND CASH FLOW ESTIMATION 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 purchase price of the required equipment is $$280,000,$ including shipping and installation costs, and the equipment is eligible for $100\%$ bonus depreciation at the time of purchase. In addition, inventories would rise by $$25,000,$ while accounts payable would increase by $$5,000.$ All of these costs would be incurred at t $=0.$

$$The project is expected to operate for $4$ years, at which time it will be terminated. The cash inflows are assumed to begin $1$ year after the project is undertaken, or at t $=1,$ and to continue out to t $=4.$ At the end of the project$$s life $($t $=4),$ the equipment is expected to have a salvage value of $$25,000.$

$$Unit sales are expected to total $100,000$ units per year, and the expected sales price is $$2\mathrm{.}00$ per unit. Cash operating costs for the project are expected to total $60\%$ of dollar sales. Allied$$s tax rate is $25\%,$ and its WACC is $10\%.$ Tentatively, the lemon juice project is assumed to be of equal risk to Allied$$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:

e$.$

$1.$What three levels, or types, of project risk are normally considered?

$2.$Which type is most relevant?

$3.$Which type is easiest to measure?

$4.$Are the three types of risk generally highly correlated?

f$.$

$1.$What is sensitivity analysis?

$2.$How would you perform a sensitivity analysis on the unit sales, salvage value, and WACC for the project? Assume that each of these variables deviates from its base$-$case, or expected, value by plus or minus $10\%,20\%,$ and $30\%.$ Explain how you would calculate the NPV$,$ IRR, MIRR, and payback for each case, but don$$t do the analysis unless your instructor asks you to$.$

$3.$What is the primary weakness of sensitivity analysis? What are its primary advantages?

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