Case study Allied Food Products is considering expanding into the fruit juice bu ing expanding into the fruit juice business with a new fresh lemon juice tly hired as assistant to the director of capital budgeting, and you product. Assume that you were recently hired as assistant to the dire be lemon juice would be produced in an unused building adjacent to must evaluate the new project. The lemon juice would be produced in an Allied's Fort Myers plant: Allied owns the building, which is fully depreciated the owns the building, which is fully depreciated. The required equipment would cost $200.000, plus an additional $40,000 for shipping and installation in addi on. 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=0By a special ruling the machinery could be depreciated under the MACRS System year property. The applicable depreciation rates are 45%, 35%, 15%, and 5%. 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 det 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 $2.00 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Allied's tax rate is 21% 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: Table 1: Allied's Lemon Juice Project L estment Outlas Equipment cost Shipping andnstallation CAPEX Increase in inventory Increase in Accounts Payable ANOWC 100,000 x $ 2.00 $ 2.00 120,000 A Project Operating Can Flows Unit sales Price per unit Total revenues Operating costs (we depm) Depreciation Total costs EBIT (Operating income Taxes on operating income EBIT (1-T) - After Tax operating income Add back depreciation EBIT (1-T). DEP 12,000 204000 14,200 12,000 3 66.720 Il Project Termination Cash Flows Salvage value Tax on salvage value After tax salvage value ANOWC - Recovery of NOWC Project Free Cash Flows EBIT1-T). DEP.CAPEX - ANOWC $25,000 15,250 192750 $20.000 3105715 3 26000) Bart 1 What is sensitivity analysis? 2. How would you perform a sensitivity analysis on the unitate 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 NPY. nd payback for each case. 3. What is the primary weakness of sensitivity analysis? What are its primary advantages? Part (D) Assume that inflation is expected to average 5% 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 5%. 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? Investment Outlays Equipment Cost Shipping and Installation CAPEX Years 2 3 45935154 4 (200.000 000 (40.000.00 (240.000.00 Increase in Inventory Increase in Accounts Payable Change in NWC S S (25 000 00 5,000 00 120 000 OON II. Project Operating Cash Flows Unit Sales Price per Unit Total Revenues Operating costs (wlo depm) T $ $ S 100 000.00 100 000 001 100 000 001100 000 00 200 $ 200 $ 200 13 2 00 200.000.00 $ 200,000.00 $ 200 000.00 $ 200,000.00 120 000 00S 120 000 00S 120 000 003 120 000 00 III. Depreciation Data Depreciation Total Costs EBIT (Opearting Income) $ $ S 108,000 00 $ 84,000 00$ 36 000.00 $ 12,000.00 228 000 00$ 204,000.00 $ 156 000.00 $ 132 000.00 (28.000 00 $ (4000.00 $ 44,000.00 $68000.00 L I IV. Operating Income Taxes on operating income Profit after taxes Add back depreciation Profit after taxes + Depn S S S (5,880 00 S (22.120.00) S 108 000 00 85880.00 S (840.00 $ 4.YOS 84,000.00 $ 80.840.00 $ 9.240 005 34.760.00 36,000.00 $ 70,760.00 $ 14 280.00 53.720.00 12,000.00 65,720.00 S V. Project Termination Cash Flows Salvage Value Tax on salvage value After Tax salvage value Recover of NWC $ S $ $ 25,000.00 (5.250.00) 19,750 00 20,000.00 Project Free Cash Flows $ (260,000.00) S 125,630.00 $ 120,590.00 $ 110,510.00 $ 105,470.00 -4840 Case study Allied Food Products is considering expanding into the fruit juice bu ing expanding into the fruit juice business with a new fresh lemon juice tly hired as assistant to the director of capital budgeting, and you product. Assume that you were recently hired as assistant to the dire be lemon juice would be produced in an unused building adjacent to must evaluate the new project. The lemon juice would be produced in an Allied's Fort Myers plant: Allied owns the building, which is fully depreciated the owns the building, which is fully depreciated. The required equipment would cost $200.000, plus an additional $40,000 for shipping and installation in addi on. 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=0By a special ruling the machinery could be depreciated under the MACRS System year property. The applicable depreciation rates are 45%, 35%, 15%, and 5%. 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 det 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 $2.00 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Allied's tax rate is 21% 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: Table 1: Allied's Lemon Juice Project L estment Outlas Equipment cost Shipping andnstallation CAPEX Increase in inventory Increase in Accounts Payable ANOWC 100,000 x $ 2.00 $ 2.00 120,000 A Project Operating Can Flows Unit sales Price per unit Total revenues Operating costs (we depm) Depreciation Total costs EBIT (Operating income Taxes on operating income EBIT (1-T) - After Tax operating income Add back depreciation EBIT (1-T). DEP 12,000 204000 14,200 12,000 3 66.720 Il Project Termination Cash Flows Salvage value Tax on salvage value After tax salvage value ANOWC - Recovery of NOWC Project Free Cash Flows EBIT1-T). DEP.CAPEX - ANOWC $25,000 15,250 192750 $20.000 3105715 3 26000) Bart 1 What is sensitivity analysis? 2. How would you perform a sensitivity analysis on the unitate 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 NPY. nd payback for each case. 3. What is the primary weakness of sensitivity analysis? What are its primary advantages? Part (D) Assume that inflation is expected to average 5% 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 5%. 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? Investment Outlays Equipment Cost Shipping and Installation CAPEX Years 2 3 45935154 4 (200.000 000 (40.000.00 (240.000.00 Increase in Inventory Increase in Accounts Payable Change in NWC S S (25 000 00 5,000 00 120 000 OON II. Project Operating Cash Flows Unit Sales Price per Unit Total Revenues Operating costs (wlo depm) T $ $ S 100 000.00 100 000 001 100 000 001100 000 00 200 $ 200 $ 200 13 2 00 200.000.00 $ 200,000.00 $ 200 000.00 $ 200,000.00 120 000 00S 120 000 00S 120 000 003 120 000 00 III. Depreciation Data Depreciation Total Costs EBIT (Opearting Income) $ $ S 108,000 00 $ 84,000 00$ 36 000.00 $ 12,000.00 228 000 00$ 204,000.00 $ 156 000.00 $ 132 000.00 (28.000 00 $ (4000.00 $ 44,000.00 $68000.00 L I IV. Operating Income Taxes on operating income Profit after taxes Add back depreciation Profit after taxes + Depn S S S (5,880 00 S (22.120.00) S 108 000 00 85880.00 S (840.00 $ 4.YOS 84,000.00 $ 80.840.00 $ 9.240 005 34.760.00 36,000.00 $ 70,760.00 $ 14 280.00 53.720.00 12,000.00 65,720.00 S V. Project Termination Cash Flows Salvage Value Tax on salvage value After Tax salvage value Recover of NWC $ S $ $ 25,000.00 (5.250.00) 19,750 00 20,000.00 Project Free Cash Flows $ (260,000.00) S 125,630.00 $ 120,590.00 $ 110,510.00 $ 105,470.00 -4840