Case

AAA Health, Inc. $($NYSE: A$3$H$)$ 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.

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 project$$s 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.

$$ Tax rate: AAA$$s 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\mathrm{.}10.$

$$ A$3$H can issue preferred stock with an offering price of $$25\mathrm{.}00$ per share, an annual per$-$share

dividend of $$2\mathrm{.}40.$ Flotation costs are equal to $4\mathrm{.}0\%$ of the gross proceeds.

$$ Ten$-$year Treasury bond yield $=5\mathrm{.}52\%$; the market risk premium $=5\%$; the beta of A$3$H $=$

$1\mathrm{.}6.$

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

equity.

$$ A$3$H 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.

Answer Questions $6-15$

Assume that there is no alternative use for the building that will be used for the project.

$6.$ 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 annual total after$-$tax cash flow for Year $0$ to Year $4$