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.
