ABC Manufacturing: show incremental cash flows and calculate payback period
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I am having touble with this problem. I've figured out my other ones, but my calculations do not seem right with this one. There is an excel sheet attached which is to be used for the problem below.
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ABC Manufacturing is thinking of launching a new product. The company expects to sell $900,000 of the new product in the first year and $1,500,000 each year thereafter. Direct costs including labor and materials will be 55% of sales. Indirect incremental costs are estimated at $80,000 a year. The project requires a new plant that will cost a total of $1,000,000, which will be depreciated straight line over the next five years. The new line will also require an additional net investment in inventory and receivables in the amount of 100,000. Assume there is no need for additional investment in building and land for the project. The firm's marginal tax rate is 40%, and its cost of capital is 10%. Based on this information you are to complete the following tasks.
1. Prepare a statement showing the incremental cash flows for this project over an 8-year period.
2. Calculate the Payback Period and the NPV for the project.
3. Based on your answer for question 2, do you think the project should be accepted? Why? Assume ABC has a P/B policy of not accepting projects with life of over three years.
4. If the project required additional investment in land and building, how would this affect your decision? Explain.
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Solution Summary
Here is just a sample of what you'll find in this solution:
"As you can read the working capital is recovered so for the end of the year 8 it will be zero or: ChWC8 = $100,000"
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1.Prepare a statement showing the incremental cash flows for this project over an 8-year period.
First of all we need to order the data and do some preliminary calculations.
-Initial investment:
The total initial investment (I) is the sum of the invest in plant and
equipment.
I = $1,000,000
-Working Capital:
The additional net investment in inventory and receivables is the
working capital needed for the project:
WC = $100,000
Because we have no additional info about the WC we assume that it will
not change over the project's life. Then Working Capital Change for
each year Yi is:
ChWCi = Previous Year WC - Current WC = 0 (i=1 to 7)and
ChWC0 = -$100,000
As you can read the working capital is recovered so for the end of the
year 8 it will be zero or:
ChWC8 = $100,000
-Depreciation:
For the first five years Yi (i = 1 to 5):
Di = (Invest in plant and equipment) / 5 = $1,000,000/5 = $200,000
For the years 6 to 8 the depreciation will be zero.
-Revenues:
For the first year the expected revenues will be:
R1 = $900,000
For the years Yi (i=2 to 8)
Ri = $1,500,000
-Expenses:
For all years we will have indirect incremental costs of $80,000
For each year the direct costs are 0.55*Ri
For each year Yi (i=1 to 8):
Ei = $80,000 + 0.55*Ri then:
E1 = $80,000 + 0.55*$900,000 = $575,000
For i=2 to 8:
Ei = $80,000 + 0.55*$1,500,000 = $905,000
-Taxes:
The firm's marginal tax ...
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