Discuss two project options the firm could consider which can impact your earlier valuation of the project..
After reviewing the data provided, you realise that the revenue and cost figures have not been adjusted for inflation which is expected to average 5% p.a. over the next 4 years. Specifically, the sales price of $4.50 per carton is expected to increase at a rate of 5% p.a. after Year 1. On the other hand, operating costs, inventory and advertising expenses are expected to increase at a rate of 2% p.a. from the initial cost estimates because these are largely fixed by contracts.
Your task as a financial analyst is to prepare a capital budgeting report to Mr Harvey and executive committee of Goodhealth Drinks Company indicating whether the firm should accept or reject the lemonade project. You are also required to provide summaries of the risk analyses for sensitive variables and break-even sales volume and prices. Address the following:
1. Estimate the appropriate Weighted Average Cost of Capital (WACC) applicable as the project’s required rate of return.
2. Prepare the incremental cash flow table for the fresh lemonade project over the first four years of operations based on annual sales quantity of 350,000 cartons. Include adjustments for inflation in your cash flow projections. Discuss if the following items should be included (or excluded) in the cash flow statement: (a) The interest expenses on the $250,000 loan; (b) The $80,000 spent to rehabilitate the plant; (c) The reduction in Goodhealth’s frozen lemonade sales and associated production costs; and (d) Opportunity of leasing the lemonade production site for $10,000 per year.
3. Assume the company uses a payback rule with a cut-off period of two years. What are the payback period, net present value (NPV), internal rate of return (IRR) and profitability index (PI) of this project? Should the project be undertaken based on each of the investment evaluation methods? Discuss.
4. Evaluate the sensitivities of the project’s NPV against variations to: unit sales, sales price per carton, inventory costs, and the salvage value. Advise management which two variables will need to be scrutinised carefully if the project is implemented.
5. Determine the break-even sales volume and break-even sales price in order for this project to be viable, under the expected cash flow projections.
6. Suggest two possible risks or opportunities that may impact the feasibility of continuing with the fresh lemonade line after 4 years. Discuss two project options the firm could consider which can impact your earlier valuation of the project.
Marking Guide
Question 1 WACC calculation
6 marks
Question 2 Discussions Incremental cash flow table
4 marks 15 marks
Question 3 Project evaluation and discussion
5 marks
