Gustav is a visionary company in the market for cat food. The company bears the name of its esteemed owner, Gustav Gustavson, a world-renowned financier, and food lover. Combining his two passions (finance and food), Gustav introduced various organic mouthwatering culinary creations inspired by the menus of different Michelin-starred restaurants. The reason was simple: cats deserve the best and nothing less than their human friends.
Gustav is considering expanding his business with a new fresh meat food product. Because Gustav leaves on a business trip, he asked you to evaluate the free cash flows generated by this project and perform several sensitivity analyses. He will make the final decision.
The product will be produced in a building owned by Gustav. The building is fully depreciated, and it is not currently in use. However, Gustav can rent the building to his brother Kasper for $25,000 per year starting next year.
The required equipment would cost $200,000 plus an additional $30,000 in shipping and $10,000 in installation. The machinery could be depreciated under the MACRS system as 3-year property. In addition, inventories would rise by $20,000, while accounts payable would increase by $5,000 and accounts receivables by $5,000. The project is expected to operate for 4 years when it will be terminated. At the end of the project's life, the equipment is expected to have a salvage value of $25,000.
Unit sales are expected to total 100,000 units per year, and the expected sales price is $2.00 per unit during the first year. The selling price will increase by 3% annually with inflation. Cash operating costs for the project are expected to total 60% of sales.
Gustav expects the new product to take sales away from his existing business. He estimates a loss of $5,000 per year.
The company’s tax rate is 40%.
Completion Instructions:
1. What are the FCFs associated with this project? 2. Gustav calculated the company’s cost of capital for you. It is 5%. a) Using NPV, IRR, and MIRR, what would you advise Gustav? Do you reach the same conclusion using all three capital budgeting criteria? b) Using the payback method, how long does it take to recoup the initial investment? What if you use the discounted payback method? 3. Gustav likes to consider all the factors. Therefore, he asked you to perform a sensitivity analysis. He asked you to assume that sales deviate from the base value of 100,000 by plus or minus 10%, 20%, and 30%. How will these changes affect the annual FCFs? How will they change your decision? 4. What if the cost of capital changes? Perform a sensitivity analysis with the cost of capital varying between 2% and 7%. (Use 1% increments.) What happens with the NPV as the cost of capital increases? How does your decision change? What happens with the IRR as the cost of capital increases? How does your decision change? 5. Gustav has also conducted a $500,000 market research. He concluded he could charge $3 instead of $2 per unit. How does the market research change the FCFs and your recommendation?
Submission Instructions:
Submit all answers in one Excel spreadsheet
Extra :
- Part 1 - FCFs - 2.5 points
- Part 2 - NPV, IRR, and MIRR - 1 point each - 3 points
- Part 2 - PB and DPB - 0.5 points each - 1 point
- Part 3 - 1 point
- Part 4 - NPV and cost of capital - 1 point
- Part 4 - IRR and cost of capital - 1 point
- Part 5 - 0.5 points
You can receive partial credit. For example, even if your FCFs are incorrect, but your NPV calculations are correct, you will still receive 1 point for finding the net present value.