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Capital Budgeting Using Cash Flows

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Operating cash flows, rather than accounting profits, are the basis for which capital budgeting projects are evaluated. What is the basis for this emphasis on cash flows as opposed to net income?

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The definition of a capital budgeting project is the process of comparing, evaluating, selecting and following up on capital expenditures to determine the real cost of a hard asset in terms of discounted cash values, or an internal rate of return calculation. The asset is expected to benefit the company for a period of time longer than a year and usually much longer.

One of the reasons that the process is so different from budgeting for results of operations is that the purchase of a capital asset is often a major financial undertaking which will effect the company for years to come; at least, for the life of the asset. In operations, a company buys or makes something, sells it, collects revenue and is done with the transaction. A capital purchase is with the company for years, for better or worse. A mistake can be costly, and this process is actually one of valuing an asset purchase over the expected life of the asset.

A capital asset is normally a ...

Solution Summary

A comprehensive 650 word discussion about the process of acquiring capital assets and the planning useful in doing so.

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Capital Budgeting and Cash Flow Estimation for Allied Food Products

Read the Allied Food Products Integrated Case Study in Fundamentals of Financial Management p. 449. Create a portfolio by answering questions a, b, c, and d about the case study. Submit the completed project using the table in this appendix.

11-12 Capital Budgeting and Cash Flow Estimation
Afterseeing Snapple's success with noncola 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 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. You have been asked to evaluate the projects 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 questions.

a. Draw a time line that shows when the net cash inflows and outflows will occur, and explain how the time line can be used to help structure the analysis.

b. Allied has a standard form that is used in the capital budgeting process; see Table IC11-1. Part of the table has been completed, but you must replace the blanks with the missing numbers. Complete the table in the following steps:

(1) Fill in the blanks under Year 0 for the initial investment outlay.

(2) Complete the table for unit sales, sales price, total revenues, and operating costs excluding depreciation.

(3) Complete the depreciation data.

(4) Now complete the table down to operating income after taxes, and then down to net cash flows.

(5) Now fill in the blanks under Year 4 for the terminal cash flows, and complete the net cash flow line. Discuss net operating working capital. What would have
happened if the machinery were sold for less than its book value?

c. (1) Allied uses debt in its capital structure, so some of the money used to finance the project will be debt. Given this fact, should the projected cash flows be revised to show projected interest charges? Explain.

(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) Now 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) Now assume that the lemon juice project would take away profitable sales from Allied's fresh orange juice business. Should that fact be reflected in your analysis?
If so, how?

d. Disregard all the assumptions made in part c, and assume there was no alternative use for the building over the next 4 years. Now calculate the project's NPV, IRR, MIRR, and regular payback. Do these indicators suggest that the
project should be accepted?

e. If this project had been a replacement rather than an expansion project, how would the analysis have changed? Think about the changes that would have to occur in the cash flow table.
f. Assume that inflation is expected to average 5 percent over the next 4 years; that this expectation is reflected in the WACC; and that inflation will increase variable costs and revenues by the same percentage, 5 percent. Does it appear that inflation has been dealt with properly in the analysis? If not, what should be done, and how would the required adjustment affect the decision? You can modify the numbers in the table to quantify your results.

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