Reference no: EM133015565
Question - ABC Ltd. plans to introduce a new flavour of ice cream to the market. The marketing team has completed a $10,000 feasibility study to assess the demand for the new ice cream. To carry out this project, the company needs to purchase a new machine at the cost of $150,000 today.
It will be fully depreciated on a straight-line basis over 10 years. You expect that the new machine will produce an incremental sales revenue of $50,000 per year for the next 5 years, with the cost of goods sold to be $20,000 per year. It is expected that the new ice cream will cannibalize the demand for the existing products at an amount of $3,000 per year. Assume that you can sell the machine after 5 years for $90,000. The company requires a 10% of the next year's sales at the commencement of the project as the net working capital.
This is assumed to be fully recoverable at the end of the project. The company's tax rate is 45%.
(a) Estimate the after-tax cash flows for the project using the accounting flow and the cash flow table. IMPORTANT: You must show each input in your table as a separate row. DO NOT group inputs together.
(b) In your capital budgeting analysis, you would have to adjust the depreciation in both accounting flow table and cash flow table. Discuss the logic and the purpose of the adjustment of depreciation.
(c) Using NPV analysis, should ABC Ltd. go ahead with the project? Assume its cost of capital is 10%.
(d) You have also calculated the IRR for this project to be 6.35%. Is the IRR rule give you the same conclusion as NPV rule? Explain.
(e) Determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged and explain.
(f) To make your existing ice cream more attractive, the company plan to provide sprinkle toppings for free. There are two types of sprinkle equipment that is available on the market. The SP1 cost $400 to buy, and it will last for three years. The SP2 costs $550 to buy, and it will last for four years. The company expects to keep this free topping service in the future, and they would replace the equipment at the end of its life. Which equipment should the company buy, assume the cost of capital is 10%.
(g) The 10% cost of capital in the questions above assumes that the project would share the same systematic risks and financing with the same capital structure as ABC Ltd. Discuss what may be the potential issue with this assumption on the discount rate.