Gammy is considering building a facility to manufacture cupcakes to
distribute nationally. Your assignment involves both the calculation
of cash flows associated with the new investment under consideration and the
evaluation of several mutually exclusive projects. Grammy wants you
to meet with everyone involved and write a meeting report for the board of
directors that includes your recommendation. In addition to the
recommendation, you have been asked to respond to a number of questions aimed
at understanding the capital-budgeting process. Grammy wants to be sure
that she and the board of directors understand cash flow and capital budgeting.
We are considering constructing a building to manufacture
cupcakes. Currently we are in the 34 percent marginal tax bracket
with a 15 percent required rate of return or cost of capital. This
project is expected to last 5 years and then, because this is somewhat of a fad
product, be terminated. The following information describes the
project:
Cost of new plant and
equipment $7,900,000
Shipping and installation costs $100,000
Unit Sales Year
Units Sold
1 70,000
2 120,000
3 140,000
4 80,000
5 60,000
Sales price per unit $300/unit in years 1 through 4,
$260/unit in year 5
Variable cost per unit $180/unit
Annual fixed costs $200,000 per year in years 1 – 5
Working-capital requirements
There will be an initial working-capital requirement of $100,000 just to
get production started. For each year, the total investment in net
working capital will be equal to 10 percent of the dollar value of sales for
that year. Thus, the investment in working capital will increase
during years 1 through 3, then decrease in year 4. Finally, all
working capital is liquidated at the termination of the project at the end of
year 5.
The depreciation method
Use the simplified straight-line method over 5 years. Assume
the plant and equipment will have no salvage value after 5 years.
a. Should you focus on cash flows or accounting profits in making the
capital-budgeting decision? Should you be interested in incremental
cash flows, incremental profits, total free cash flow, or total profits?
b. How does depreciation affect free cash flow?
c. How do sunk costs affect the determination of cash flows?
d. What is the project’s initial outlay?
e. What are the differential cash flows over the project’s life?
f. What is the terminal cash flow?
g. Draw a cash-flow diagram for this project.
h. What is its net present value?
i. What is its internal rate of return?
j. Should the project be accepted? Why or why not?
TUTORIAL PREVIEW
d. What is the project’s initial outlay?
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Project's Initial outlay:
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Cost of new plant and equipment
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7,900,000
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Shipping and installation costs
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100,000
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