Part 1 Case study (25 marks)

You are placed in the role of an analyst for Hill Country Snack Food Co. Hill Country Snack Food Co is considering investing in a new product, SuperBar. You have been asked by the CEO to provide a recommendation on whether to go ahead with the investment in SuperBar. The research and development costs so far have totalled $40 million (exotic superfoods and rare minerals of dubious origin are expensive!). If approved by the CEO, SuperBar could be put on the market at the beginning of next year (Year 1), and Hill Country expects it to stay on the market for a total of four years (from Year 1 to Year 4). If the project proceeds, the initial investment will occur immediately (Year 0), and operational cash flows will occur at beginning of next year (Year 1). Hill Country must initially invest $1 million in production equipment to make the SuperBar (in Year 0). This equipment can be sold for $800,000 at the end of four years (Year 4). Hill Country would sell the SuperBar through its current channels, so sales will be able to commence as soon as the equipment is operational. SuperBar is expected to wholesale for $2 per bar. The variable cost to produce each bar is $1. In order to secure appropriate celebrity endorsement for the new SuperBar, Hill Country will incur $20 million in marketing and general administration costs in the first year (Year 1). Both selling price and costs (including variable cost and marketing and general administration cost) are expected to increase at the inflation rate in the subsequent years (Year 2 to Year 4). Hill Country's corporate tax rate is 35.5 percent. Annual inflation is expected to remain constant at 3.25 percent over the life of the project. Industry research suggests the following sales targets are reasonable: 30 million bars sold in the first year, 20 million in year two, 15 million in year three, and 15 million in year four. The production equipment would be depreciated using the straight-line depreciation method over 4 years to a zero balance. The immediate initial working capital requirement is $1 million in Year 0. At the end of Year 4, the company will get all working capital back. For the purposes of this analysis, assume a 10% discount rate is appropriate.

Please complete the following questions.

a) Calculate the incremental free cash flow during the project's life (starting from Year 0 to Year 4). Show workings. (15 marks)

b) Calculate the NPV, payback period and IRR of the project. Should the project be accepted based on NPV rule? Show workings and explain your answer(s). (10 marks)