After seeing Snapple's success with non-cola soft drinks and learning of Coke's and Pepsi's interest, Allied Food Products has decided to consider an expansion of its own in the fruit juice business. The product being considered is fresh lemon juice.
Assume that you were recently hired as an 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 an additional $40,000 for shipping and installation. In addition, inventories would rise by $25,000, while accounts payable would go up 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 cans per year, and the expected sales price is $2.00 per can. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60 percent of dollar sales. Allied's tax rate is 40 percent, and its weighted average cost of capital is 10 percent. Tentatively, the lemon juice project is assumed to be of equal risk to Allied's other assets.
Explain why this project should, or should not, be accepted.
Explain and illustrate with two examples: how one would apply scenario and sensitivity analyses to this decision.
Allied Food Products Capital Budgeting
1. See the attachment for the completed table. All cells are formulas, so you can see how each amount was calculated.
2. This project should be rejected because the present value of the future cash flows is negative. The project earns 9.28% annualized return (IRR) assuming the returns can be reinvested at that rate. This is not enough to exceed the firm's cost of capital of 10%. Since the capital cost 10%, projects that don't even pay for the capital, heaven help throw off profits in excess of the cost of capital, should be rejected. It would be better to ...
Your tutorial includes completing the model, showing two other models with a variable changes to illustrate sensitivity analysis, and a discussion of 429 words about this project.