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Finance 211 Case 2 Capital Budgeting Analysis

Dimples Baby Products (DBP), projects unit sales for its new Vegey Goo pablum, as follows:

Year Unit Sales

1 90,000

2 100,000

3 110,000

4 117,000

5 65,000

Production of the Pablum will require $10 million in net working capital to start and additional net operating working capital investments each year equal to 35 percent of the projected sales increase (in $s) for the following year. (Because sales are expected to fall in the fifth year of sales, there is no NOWC for that year). Total fixed costs are $175,000 per year, variable production costs are $227 per unit, and the units are priced at $360 each. The equipment needed to begin production is $13.2 million. The manufacturing equipment needed to make the Pablum falls into class 8 for tax purposes (20 percent). Assume at the end of year 5 this equipment can be sold for its scrap value of $1 million. To promote the industry, the government is offering a non-taxable cash grant of 500,000 payable a year after the project has been started. DBP feels its optimal capital structure is 30% debt, 60% common equity, and 10% preferred shares. According to its calculations DBP is expecting the required return on debt (before tax) to be 20%, on preferred shares 22% and on common equity 32%. Since, the company has a significant amount of capital in retained earnings they will not allocate any flotation costs to this project. DBP is in the 40 percent marginal tax bracket and this project is considered to be of average risk compared to previous investments. Note: Utilize the formula for calculating the PV of the CCA tax shield rather than the year by year calculations as it is more accurate.

1. Based on these preliminary project estimates, what is the Net Present Value of the project?

2. Calculate the projects Profitability Index, Internal Rate of Return and the Payback period.

3. Based on this analysis what would be your recommendation to DBP? Discuss any other factors or variables discussed in this course which could affect this decision. Could these additional factors be incorporated into the analysis? Explain.