INTEGRATED CASE
ALLIED FOOD PRODUCTS
CAPITAL BUDGETING AND CASH FLOW ESTIMATION Allied Food Products is considering expanding into the fruit juice business with a new fresh lemon juice product. Assume that you were recently hired as assistant to the director of capital budgeting, and you must evaluate the new project.
The lemon juice would be produced in an unused building adjacent to Allied's Fort Myers plant; Allied owns the building, which is fully depreciated. The required equipment would cost $200,000, plus on additional $40,000 for shipping and installation. In addition, inventories would rise by $25,000, while accounts payable would increase by $5,000. All of these costs would be incurred at t = 0. By a special ruling, the machinery could be depreciated under the MACRS system as 3-year property. The applicable depreciation rates are 33%, 45%, 15%, and 7%.
The project is expected to operate for 4 years, at which time it will be terminated. The cash inflows are assumed to begin 1 year after the project is undertaken, or at t = 1, and to continue out to t = 4. At the end of the project's life (t = 4), the equipment is expected to have a salvage value of $25,000.
Unit sales are expected to total 100,000 units per year, and the expected sales price is $2.00 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Allied's tax rate is 40%, and its WACC is 10%. Tentatively, the lemon juice project is assumed to be of equal risk to Allied's other assets.
You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected. To guide you in your analysis, your boss gave you the following set of tasks/ questions:
2. Suppose you learned that Allied had spent $50,000 to renovate the building last year, expensing these costs. Should this cost be reflected in the analysis? Explain.
3. Suppose you learned that Allied could lease its building to another party and earn $25,000 per year. Should that fact be reflected in the analysis? If so, how?
4. Assume that the lemon juice project would take profitable sales away from Allied's fresh orange juice business. Should that fact be reflected in your analysis? If so, how?
Allied's Lemon Juice Project (in Thousands) TABLE IC 12.1
TABLE IC 12.2 Allied's Lemon Juice Project Considering 5% Inflation (in Thousands)
2. Which type is most relevant?
3. Which type is easiest to measure?
4. Are the three types of risk generally highly correlated?
2. How would you perform a sensitivity analysis on the unit sales, salvage value, and WACC for the project? Assume that each of these variables deviates from its base-case, or expected, value by plus or minus 10%, 20%, and 30%. Explain how you would calculate the NPV, IRR, MIRR, and payback for each ease; but don't do the analysis unless your instructor asks you to.
3. What is the primary weakness of sensitivity analysis? What are its primary advantages?
Work out quantitative answers to the remaining questions only if your instructor asks you to. Also note that it will take a long time to do the calculations unless you are using an Excel model.
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