Question

11-4. Fruity Fruits Ltd. currently sells $25 million annually of apple juice in 1 litre containers and $10 million of individually packaged dried fruit snacks. The company wants to introduce a 230 mL single-serving cranberry–apple juice product next year. A $200,000 feasibility study just completed estimated yearly sales of $12 million for the new juice. The study also forecast that sales of the company's existing apple juice would fall by $2 million as some existing customers would switch to the new beverage; however, sales of the snack product would increase by 10% due its complementary nature to the new product. The company has unused land it can use, which was purchased two years ago for $500,000. That land could currently be sold for $700,000. Building and equipment costs for the new project are $1,000,000. What is the initial investment and first-year cash inflow for this project?

11-5. General Wireless has just completed market research on a new smartphone. This new phone is lighter and smaller, though more feature rich, than its existing product. New product sales are estimated at 1,000,000 units per year with a contribution margin of $40. However, if General Wireless introduces its new product, sales of its existing smartphone will fall from 600,000 to 250,000 units per year. Its existing product has a contribution margin of $30.

The market research on the new phone was $350,000. General Wireless will retool one of its existing manufacturing facilities to produce the new model. The one-time retooling cost is $3,700,000. There will also be $80,000 in retraining costs incurred for workers who lost their jobs manufacturing the existing product. The new facility is expected to increase fixed cash costs of $150,000 per year. Research and development on the new phone took 2 years at a cost of $1,900,000. The R&D group also paid an external company for use of their advanced testing facilities at a further cost of $100,000.

General Wireless has also spent $90,000 in the design of a new corporate headquarters. Building the headquarters will cost $4,000,000.

For capital budgeting purposes, calculate the project's:

Initial cost.

Annual cash flows before tax.

11-6. Marine Technologies has identified a project that will lower annual operating costs by $10,000 per year for 5 years. The equipment costs $30,000, installation and training is $5,000, and there is an initial investment in net operating working capital of $6,000. There is no expected salvage value in 5 years. Marine Technologies operates at break - even so it pays no taxes. If the company's cost of capital is 10%, what is the project's NPV?

11-8 Assume the following information for Project X:

Initial investment: $50,000

Annual after-tax cash flows: $8,000

Salvage value: $0

If the project's internal rate of return is 12.5%, what must be the life of the project (to the nearest year)?

11-9 Campbell Company is evaluating the proposed acquisition of a new milling machine. The machine's base price is $120,000, and it would cost another $9,500 to modify it for special use. The machine falls into Class 8 with a 20% CCA rate, and it would be sold after 4 years for $60,000. The machine would require an increase in net working capital (inventory) of $7,500. The milling machine would have no effect on revenues, but it is expected to save the firm $31,000 per year in before-tax operating costs, mainly labour. Campbell's marginal tax rate is 30%.

(a) What is the total initial investment for capital budgeting purposes? (That is, what is the Time 0 net cash flow?)

(b) What is the PV of the project cash flows using an 11% cost of capital?

(c) What is the PV of the CCA tax shield?

(d) What is the PV of the additional Year 4 cash flow?

(e) If the project's cost of capital is 11%, should the machine be purchased?

Answer 1

11-4

Sales of Apple juice= $25 million

Sales of dried fruits snacks= $10 million

Feasibility study was done before the start of the project which cannot be recovered and is therefore considered a sunk cost. It will not be included in the evaluation of the project.

Decrease in sales of Apple juice= $2 million

Increase in sales of Snacks= 10%*$10 million

= $1 million

The land could currently be sold for $700,000 and is therefore an opportunity cost for the company if used for the project. So, this would be considered as initial cost.

Building and equipment costs= $1 million

So, Total initial investment= Land cost+Building and equipment costs

= $700,000+ $1 million

= $1.7 million

First year cash inflow= Sales of new juice-decrease in sales of Apple juice+Increase in sales of Snacks

= $12 million-$2 million+$1 million

= $11 million