Question
Wong Catering Company is considering adding a new line to its product mix, and you are conducting the capital budgeting analysis. The production line would
Wong Catering Company is considering adding a new line to its product mix, and you are conducting the capital budgeting analysis. The production line would be set up in unused space in Wongs main plant. New machinery costs $300,000 at the start of the project. $20,000 in shipping charges will also be required at the start of the project. It will also cost an additional $10,000 to install the machinery at the start of the project. The machinery has an economic life of 4 years. The company employs the straight-line depreciation method. The machinery is expected to have a salvage value of $50,000 after 4 years of use. The new product line would generate incremental sales of 1,000 units per year for 4 years at an incremental cost of $100 per unit in the first year. Each unit can be sold for $200 in the first year. Both the sales price and cost per unit are expected to increase by 5% per year due to inflation. Further, to handle the new product line, the firm would have to make an upfront investment in net working capital equal to 11% of the first years sales revenues. This net working capital investment will be recovered at the end of the project (year 4). The firms tax rate is 30%. The firms weighted average cost of capital is 10%. Assume cashflows at end of period unless instructed otherwise. REQUIRED: (a) Set out a table of incremental cash flows arising from undertaking this project. (b) Calculate the projects Net Present Value (NPV) and the Payback Period. (c) Discuss if the company should or should not proceed with this expansion. (d) What is the rule to be aware of when calculating the Internal Rate of Return (IRR)? You are not expected to calculate the IRR.
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