Capital Budgeting Analysis

Adams, Incorporated would like to add a new line of business to its existing retail business. The new line of business will be the manufacturing and distribution of animal feeds. This is a major capital project. Adams, Incorporated is aware you an in an MBA program and would like you to help analysis the viability of this major business venture based on the following information:

• The production line would be set up in an empty lot the company owns.

• The machinery’s invoice price would be approximately $200,000, another $10,000 in shipping charges would be required, and it would cost an additional $30,000 to install the equipment.

• The machinery has useful life of 4 years, and it is a MACRS 3-year asset.

• The machinery is expected to have a salvage value of $25,000 after 4 years of use.

• This new line of business will generate incremental sales of 1,250 units per year for 4 years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 3% per year due to inflation.

• Net working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 40%, and its overall weighted average cost of capital is 10%.

Required:

1. If the company spent $40,000 last year in the upkeep of the empty lot, should this cost be included in the analysis? Why or why not?

2. Disregard the assumptions in part 1 above. What is the machinery’s depreciable basis? What are the annual depreciation expenses?

3. Calculate the annual sales revenues and costs (other than depreciation).

4. Construct annual incremental operating cash flow statements.

5. Estimate the required net working capital for each year based on sales for the following year. Working capital will be recovered at the end of year 4.

6. Calculate the after-tax salvage cash flow.

7. Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR, Profitability Index (PI), and payback?

8. Can you use the Payback method to decide whether this is a good project or not? Why or why not?

9. Interpret what NPV, IRR, and Profitability Index (PI) mean. Based on your interpretation, do these indicators suggest the new business line should be undertaken?