United Pigpen International ( UPI ) is considering a proposal to manufacture hig
ID: 2711280 • Letter: U
Question
United Pigpen International (UPI) is considering a proposal to manufacture high-protein hog feed. Yesterday, Willy Swine (the company president) sent a check in the amount of $45,000 to Ketzenberg Consultants, Inc. (KCI) as payment for a market study.
KCI projects that with a $1.2 million investment in plant at time 0 (note that for tax purposes the plant has a ten year - straight line - depreciable life), UPI will be able to generate time 1 hog feed sales of $4 million. These sales are expected to grow by 5% per year for the subsequent 3 years (t=2, 3, and 4). After year 4, however, demand is projected to drop precipitously. Consequently the plant will be shut down at t=4 and sold for $800,000.
Manufacturing costs (not including depreciation) are expected to be 80% of sales. In addition, the project will lead to an increase in accounts payable (AP) from $0 to $250,000 at t=0. At times 1, 2, and 3, AP will be $200,000, $100,000, and $40,000, respectively. AP will be reduced to $0 at time 4.
The project would make use of a vacant lot that the company presently owns. Last month, Hogs Unlimited, a local competitor, offered $700,000 (net of all taxes) to buy the lot. Although the offer seemed fair and reasonable, UPI decided not to sell. At t=4, the lot is expected to be worth $850,000 (net of all taxes).
If the appropriate required return for this type of project is 18% and the corporate tax rate is 40%, should UPI undertake this project? Be sure to quantify your answer.
Explanation / Answer
Ans
UPI should not undertake this project as NPV is negative.
Please find below the workings
Details Remarks Year 0 Year 1 Year 2 Year 3 Year 4 Market study cost Sunk Cost Initial Investment -12,00,000.00 Increase in Working capital -2,50,000.00 -50,000.00 -1,00,000.00 -60,000.00 -40,000.00 Opprtunity Cost of Land -7,00,000.00 -1,50,000.00 Operating Cash Flow Sales 40,00,000.00 42,00,000.00 44,10,000.00 46,30,500.00 Less Cost of Operations -32,00,000.00 -33,60,000.00 -35,28,000.00 -37,04,400.00 Less Depreciation Purchase Cost/Useful Life=1200000/10 -1,20,000.00 -1,20,000.00 -1,20,000.00 -1,20,000.00 Income from operation 6,80,000.00 7,20,000.00 7,62,000.00 8,06,100.00 Less Tax 40% 2,72,000.00 2,88,000.00 3,04,800.00 3,22,440.00 Profit After Tax 4,08,000.00 4,32,000.00 4,57,200.00 4,83,660.00 Add: Depreciation 1,20,000.00 1,20,000.00 1,20,000.00 1,20,000.00 Cash from Operations including reduction in WC 5,78,000.00 6,52,000.00 6,37,200.00 6,43,660.00 Net Book Value of land (1200000-(120000*4)) 7,20,000.00 Capital gain 80,000.00 Tax on capital gain 32,000.00 Disposal Value of Plant with Land 8,00,000.00 Tax on disposal -32,000.00 Oppurtunity cost of increase in the value of land -1,50,000.00 Net cash flow on disposal 6,18,000.00 DF @ 18% 1 0.847457627 0.71818443 0.608630873 0.515788875 Discounted cah flows -21,50,000.00 4,89,830.51 4,68,256.25 3,87,819.59 6,50,750.19 NPV -1,53,343.46Related Questions
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