Question

AGOURA MANUFACTURING MINI-CASE

Agoura Manufacturing has announced the introduction of a new product. They forecast product- specific sales demand to last five years. Then because this product is somewhat of a fad, they will terminate the project. Manufacturing of the product will require the acquisition of an existing facility and purchase and installation of some new equipment. The following information describes the new project:

Capital Investment requirement:

Cost of new plant and equipment:      $13,750,000 Shipping and installation costs:                          $   465,000

Working Capital requirements:

An initial working-capital requirement of $350,000 will accompany the start of production. After that, total investment in net working capital during each year will be equal to 16 percent of the dollar value of sales for that year. Therefore, the working capital investment required will increase during years 1 through 3, decrease in year 4, and finally, all working capital is converted to cash at the termination of the project at the end of year 5.

Sales Forecast:

Year	Units Sold
1	75,000
2	115,000
3	195,000
4	75,000
5	45,000

Sales price per unit: $275/unit in years 1–4, $180/unit in year 5 Variable cost per unit: $215/unit

Annual fixed costs: $675,000

Other Assumptions:

Agoura Manufacturing uses the simplified straight-line depreciation method over useful life. The plant and equipment will have no salvage value after five years. Agoura Manufacturing pays taxes at a 34% marginal rate. Their cost of capital is 17%, and this project offers a similar risk profile to the company’s overall operations.

1. Determine the incremental cash flows Agoura could expect from the project in each year 1 to 5. How do these cash flows differ from accounting profits or earnings?

Answer 1

1]		0	1	2	3	4	5
	Units sold		75000	115000	195000	75000	45000
	Price per unit		$                   275	$                   275	$                  275	$                 275	$               180
	Sales		$    2,06,25,000	$   3,16,25,000	$   5,36,25,000	$ 2,06,25,000	$   81,00,000
	-Variable cost at $215/unit		$    1,61,25,000	$   2,47,25,000	$   4,19,25,000	$ 1,61,25,000	$   96,75,000
	-Annual fixed costs		$          6,75,000	$         6,75,000	$         6,75,000	$        6,75,000	$     6,75,000
	-Depreciation [(13750000+465000)/5]		$       28,43,000	$       28,43,000	$      28,43,000	$     28,43,000	$   28,43,000
	=NOI		$          9,82,000	$       33,82,000	$      81,82,000	$        9,82,000	$ -50,93,000
	-Taxes at 34%		$          3,33,880	$       11,49,880	$      27,81,880	$        3,33,880	$ -17,31,620
	=NOPAT		$          6,48,120	$       22,32,120	$      54,00,120	$        6,48,120	$ -33,61,380
	+Depreciation		$       28,43,000	$       28,43,000	$      28,43,000	$     28,43,000	$   28,43,000
	=OCF		$       34,91,120	$       50,75,120	$      82,43,120	$     34,91,120	$    -5,18,380
	-Capital expenditure [13750000+465000]	$   1,42,15,000
	-Change in NWC	$         3,50,000	$       29,50,000	$       17,60,000	$      35,20,000	$    -52,80,000	$ -33,00,000
	=Incremental cash flows from each year	$ -1,45,65,000	$          5,41,120	$       33,15,120	$      47,23,120	$     87,71,120	$   27,81,620
2]	Accounting profits are based on the accrual system, but project cash flows are based on expected cash flows.
	To arrive at expected cash flows, at first, depreciation is added back to the accounting profits as, depreciation is not a cash expenditure.
	This will accounting cash profits. [Remember that for capital budget analysis, interest expense is not considered. Hence, accounting
	profit refers to net operating profit after tax.]
	To the cash profit so arrived at, changes in NWC are adjusted to get the project cash flows. NWC is recovered in the last year.
	The after tax salvage value of the investment in the last year is a cash flow for the project.