Allied Juice

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.

ALLIED FOOD PRODUCTS

11-12 Capital Budgeting and Cash Flow Estimation After

seeing 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.

We make our time line with the calculated figures as below

0 1 2 3 4

| | | | |

(260) 79.7 91.2 62.4 89.7

The time lines show when the cash flows occur. Once we have the figures and they have been entered in the time line, we can easily calculate the various indicators such as payback period, IRR or NPV.

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.

In capital budgeting the financing decisions are not taken. The discounting rate takes care of the financing. The discounting rate takes care of the total cost of capital (including debt and equity), and so there is no need to show the interest charges separately.

(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.

This expenditure will be called a sunk cost, since it was incurred prior to the project and cannot be recovered. As we know that sunk costs should not be included in the project analysis.

(3)

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