NASTY-AS-CAN-BE CAND National Foods is considering producing a new candy, Nasty-

Question

NASTY-AS-CAN-BE CAND 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 S300,000 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 recommendation 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 produce this new candy considering this possible drop in sales? Explain.

Explanation / Answer

a. The NPV of the project is calculated as shown in the table below:

Since the NPV is positive, it is recommended to produce the candy

b. When the production cost changes from 60% to 65%, the NPV becomes neagtive as shown in the table and the recommendation changes as not to produce the candy.

c. When MACRS depreciation is used, the recommendation stays the same which is to produce the candy as NPV is still positive as shown below:

d. When the sale drop 5% each year, NPV becomes negative and National foods should not produce the candy.

Year 0 1 2 3 4 5 6 7 8 9 10 Initial Cost -1000000 Additional WC -300000 Revenue 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 Production Cost -1200000 -1200000 -1200000 -1200000 -1200000 -1200000 -1200000 -1200000 -1200000 -1200000 Sales Overhead -525000 -525000 -525000 -525000 -525000 -525000 -525000 -525000 -525000 -525000 Dep. -100000 -100000 -100000 -100000 -100000 -100000 -100000 -100000 -100000 -100000 Profit before tax 175000 175000 175000 175000 175000 175000 175000 175000 175000 175000 Taxes at 45% -78750 -78750 -78750 -78750 -78750 -78750 -78750 -78750 -78750 -78750 Net Profit 96250 96250 96250 96250 96250 96250 96250 96250 96250 96250 Add back Dep. 100000 100000 100000 100000 100000 100000 100000 100000 100000 100000 Return of Adln. WC 300000 Net Cash flow -1300000 196250 196250 196250 196250 196250 196250 196250 196250 196250 496250 NPV at 8% $ 155,811.52

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