Case for Section || NASTY-AS-CAN-BE CANDY National Foods is considering producin

Question

Case for Section ||

NASTY-AS-CAN-BE CANDY

National Foods is considering producing a new candy, Nasty-As- Can-Be. National has spent two years and $450,000 developing this product. National has also test marketed Nasty, spending $100,000 to conduct consumer surveys and tests of the product in 25 states.

Based on previous candy products and the results in the test marketing, management believes consumers will buy 4 million packages each year for ten years at 50 cents per package. Equipment to produce Nasty will cost National $1,000,000, and $300,000 of additional net working capital will be required to support Nasty sales. National expects production costs to average 60% of Nasty’s net revenues, with overhead and sales expenses totaling $525,000 per year. The equipment has a life of ten years, after which time it will have no salvage value. Working capital is assumed to be fully recovered at the end of ten years. Depreciation is straight-line (no salvage) and National’s tax rate is 45%. The required rate of return for projects of similar risk is 8%.

Requirements

a. Should National Foods produce this new candy? What is the basis of your recommendation?
b. Would your recommendation change if production costs average 65% of net revenues instead of 60%? How sensitive is your recom- mendation to production costs?

c. Would your recommendation change if the equipment were depreciated according to MACRS as a 10-year asset instead of using straight-line?
d. Suppose that competitors are expected to introduce similar candy products to compete with Nasty, such that dollar sales will drop by 5% each year following the first-year. Should National Foods pro- duce this new candy considering this possible drop in sales? Explain.

Explanation / Answer

Note: Answers to requirements b,c and d are worked as independent variations from the solution to (a).

INVESTMENT CASH FLOWS AT T=0: cost of equipment 1000000 addition to NWC 300000 Total initial investment 1300000 ANNUAL OPERATING CASH FLOWS: sales (4 million*$0.5) 2000000 production costs (60%) 1200000 overhead & sales expenses 525000 depreciation (1000000/10) 100000 profit before tax 175000 tax at 45% 78750 profit after tax 96250 add: depreciation 100000 annual operating cash flows 196250 TERMINAL CASH FLOWS: recovery of working capital 300000 a) Yes, the new candy should be produced as the NPV is positive. PV of operating cash flows = 196250*pvifa(8,10) = 196250*6.7101= 1316857 PV of terminal cash flow = 300000*pvif(8,10) = 300000*0.4632 = 138960 PV of cash inflows 1455817 Less: Initial investment 1300000 NPV 155817 b) AS the NPV is negative, the project has to be rejected. sales (4 million*$0.5) 2000000 production costs (65%) 1300000 overhead & sales expenses 525000 depreciation (1000000/10) 100000 profit before tax 75000 tax at 45% 33750 profit after tax 41250 add: depreciation 100000 annual operating cash flows 141250 TERMINAL CASH FLOWS: recovery of working capital 300000 a) Yes, the new candy should be produced as the NPV is positive. PV of operating cash flows = 141250*pvifa(8,10) = 141250*6.7101= 947802 PV of terminal cash flow = 300000*pvif(8,10) = 300000*0.4632 = 138960 PV of cash inflows 1086762 Less: Initial investment 1300000 NPV -213238 The sensitivity of NPV to the cost of production = Change in NPV/Change in production costs = (-213238-155817)/(1300000-1200000) = $   (3.69) For every dollar change in total production costs, the NPV changes $3.69 in the opposite direction. c) With MACRS depreciation )60% costs): The annual operating cash flows would vary and would be a below: 1 2 3 4 5 6 7 8 9 10 sales (4 million*$0.5) 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 production costs (60%) 1200000 1200000 1200000 1200000 1200000 1200000 1200000 1200000 1200000 1200000 overhead & sales expenses 525000 525000 525000 525000 525000 525000 525000 525000 525000 525000 MACRS depreciation rate % 10.000 18.000 14.400 11.520 9.216 7.373 6.554 6.554 6.554 6.554 depreciation 100000 180000 144000 115200 92160 73730 65540 65540 65540 65540 profit before tax 175000 95000 131000 159800 182840 201270 209460 209460 209460 209460 tax at 45% 78750 42750 58950 71910 82278 90571.5 94257 94257 94257 94257 profit after tax 96250 52250 72050 87890 100562 110698.5 115203 115203 115203 115203 add: depreciation 100000 180000 144000 115200 92160 73730 65540 65540 65540 65540 annual operating cash flows 196250 232250 216050 203090 192722 184428.5 180743 180743 180743 180743 pvif at 8% 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403 0.5002 0.4632 PV at 8% 181713 199117 171507 149277 131163 116221 105462 97650 90416 83719 Total PV 1326246 Terminal cash flows: release of working capital 300000 tax shield on loss on disposal (1000000-967250)*0.45 14738 314738 PV at 8% (314738*0.4632) 145786 Calculation of NPV: PV of annual cash inflows 1326246 PV of terminal cash flows 145786 PV of cash inflows 1472033 Less: initial investment 1300000 NPV 172033 With MACRS depreciation the NPV increases and the project is still viable. d) With 5% drop in dollar sales (with SLM depreciation): 1 2 3 4 5 6 7 8 9 10 sales (4 million*$0.5) 2000000 1900000 1805000 1714750 1629013 1547562 1470184 1396675 1326841 1260499 production costs (60%) 1200000 1200000 1200000 1200000 1200000 1200000 1200000 1200000 1200000 1200000 overhead & sales expenses 525000 525000 525000 525000 525000 525000 525000 525000 525000 525000 depreciation 100000 100000 100000 100000 100000 100000 100000 100000 100000 100000 profit before tax 175000 75000 -20000 -110250 -195988 -277438 -354816 -428325 -498159 -564501 tax at 45% 78750 33750 -9000 -49612.5 -88194.4 -124847 -159667 -192746 -224172 -254026 profit after tax 96250 41250 -11000 -60637.5 -107793 -152591 -195149 -235579 -273988 -310476 add: depreciation 100000 100000 100000 100000 100000 100000 100000 100000 100000 100000 annual operating cash flows 196250 141250 89000 39362.5 -7793.13 -52591 -95148.9 -135579 -173988 -210476 pvif at 8% 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403 0.5002 0.4632 PV at 8% 181713 121099 70651 28933 -5304 -33141 -55518 -73249 -87037 -97491 Total PV 50655 Terminal cash flows: release of working capital 300000 PV - 0.4632*300000 138960 Calculation of NPV: PV of annual cash inflows 50655 PV of terminal cash flows 138960 PV of cash inflows 189615 Less: initial investment 1300000 NPV -1110385 As the NPV is negative, the project cannot be accepted.

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