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A manufacturing company is considering launching a new product. The company expects to sell $950,000 of the new product in the first year and $1,500,000 annually thereafter. Direct costs, including labor and materials, will be 45% of sales. Indirect incremental costs are estimated at $95,000 per year. The project requires a new plant costing $1,500,000, depreciated straight-line over 5 years. Additionally, an investment of $200,000 in inventory and receivables is needed. The company's marginal tax rate is 35%, and its cost of capital is 10%. Prepare a statement showing the incremental cash flows over 8 years, calculate the payback period (P/B) and net present value (NPV), and analyze whether the project should be accepted based on these metrics. Discuss how additional investments in land and building would influence the decision within the company's policy of not accepting projects with a payback exceeding 3 years.
Paper For Above instruction
Introduction
Launching a new product involves a comprehensive financial analysis to determine its attractiveness and strategic fit for a company. Critical to this assessment are the projected cash flows, payback period, and net present value (NPV), which provide insights into the investment's profitability and risk. This paper meticulously calculates the incremental cash flows over eight years for the proposed product launch, evaluates the project's economic viability using payback and NPV metrics, and discusses the implications of additional investments on the decision-making process considering the company's policy constraints.
Incremental Cash Flows Calculation
The foundation of project evaluation is establishing the incremental cash flows, which represent the additional cash generated solely due to the new product launch. This process includes considering revenues, costs, taxes, depreciation, and changes in working capital.
Yearly Sales and Costs:
- Year 1 sales: $950,000
- Subsequent years' sales: $1,500,000 annually
- Direct costs: 45% of sales
Depreciation:
- The new plant costs $1,500,000 and is depreciated straight-line over 5 years:
\[ \text{Annual Depreciation} = \frac{\$1,500,000}{5} = \$300,000 \]
Initial Investment:
- Plant purchase: $1,500,000
- Working capital (inventory and receivables): $200,000
- Total initial outflow: $1,700,000 (plant + working capital)
Yearly Operating Cash Flows:
1. Revenue:
- Year 1: $950,000
- Years 2-8: $1,500,000
2. Variable costs:
- 45% of sales
3. Fixed costs:
- $95,000 annually
4. Earnings Before Tax (EBT):
\[
\text{EBT} = \text{Sales} - \text{Variable costs} - \text{Fixed costs} - \text{Depreciation}
\]
5. Tax:
\[
\text{Tax} = \text{EBT} \times 35\%
\]
6. Net Operating Profit After Taxes (NOPAT):
\[
\text{NOPAT} = \text{EBT} - \text{Tax}
\]
7. Add back depreciation (non-cash expense):
\[
\text{Operating Cash Flow} = \text{NOPAT} + \text{Depreciation}
\]
8. Recovery of working capital occurs at the end of the project (year 8).
Applying these calculations:
Year 1:
- Sales: $950,000
- Variable costs: 45% × $950,000 = $427,500
- Fixed costs: $95,000
- Depreciation: $300,000
Calculations:
\[
\text{EBIT} = 950,000 - 427,500 - 95,000 - 300,000 = 127,500
\]
\[
\text{Taxes} = 127,500 \times 0.35 = 44,625
\]
\[
\text{NOPAT} = 127,500 - 44,625 = 82,875
\]
\[
\text{Operating Cash Flow} = 82,875 + 300,000 = 382,875
\]
Years 2-8:
- Sales: $1,500,000
- Variable costs: 45% × $1,500,000 = $675,000
Calculations:
\[
\text{EBIT} = 1,500,000 - 675,000 - 95,000 - 300,000 = 430,000
\]
\[
\text{Taxes} = 430,000 \times 0.35 = 150,500
\]
\[
\text{NOPAT} = 430,000 - 150,500 = 279,500
\]
\[
\text{Operating Cash Flow} = 279,500 + 300,000 = 579,500
\]
Year 8 special treatment:
- Recover initial working capital investment of $200,000:
\[
\text{Total cash inflow at year 8} = 579,500 + 200,000 = 779,500
\]
- Depreciation in Year 8 continues at $300,000, but it does not affect cash flow, only taxes.
NPV and Payback Period Calculations
Net Present Value (NPV):
Using a discount rate of 10%, we discount each year's cash flow:
\[
\text{NPV} = \sum_{t=1}^8 \frac{\text{Cash flow}_t}{(1 + 0.10)^t} - \text{Initial investment}
\]
Calculations:
- Year 1:
\[
\frac{\$382,875}{(1.10)^1} = \$348,977
\]
- Years 2-7:
\[
\frac{\$579,500}{(1.10)^2} = \$479,132
\]
\[
\frac{\$579,500}{(1.10)^3} = \$435,578
\]
\[
\frac{\$579,500}{(1.10)^4} = \$395,07
\]
\[
\frac{\$579,500}{(1.10)^5} = \$359,15
\]
\[
\frac{\$579,500}{(1.10)^6} = \$326,50
\]
\[
\frac{\$579,500}{(1.10)^7} = \$296,82
\]
- Year 8:
\[
\frac{\$779,500}{(1.10)^8} = \$366,226
\]
Sum of discounted cash flows:
\[
\text{Total} \approx \$348,977 + \$479,132 + \$435,578 + \$395,007 + \$359,150 + \$326,500 + \$296,820 + \$366,226 = \$3,007,390
\]
Subtract initial investment of $1,700,000:
\[
\text{NPV} = \$3,007,390 - \$1,700,000 = \$1,307,390
\]
Payback Period:
Cumulative cash flow annually:
- Year 1: $382,875
- Year 2: $382,875 + $579,500 = $962,375
- Year 3: $962,375 + $579,500 = $1,541,875
The initial investment ($1,700,000) is recovered between years 3 and 4. Since after Year 3, $1,541,875 has been recovered, remaining:
\[
\$1,700,000 - \$1,541,875 = \$158,125
\]
Year 4 cash flow:
\[
\$579,500
\]
Number of months to recover remaining amount:
\[
\frac{\$158,125}{\$579,500} \approx 0.272 \text{ year} \approx 3.27 \text{ months}
\]
Thus, payback period:
\[
\text{Approximately 3 years and 3 months}
\]
Discussion and Decision
The calculated NPV of approximately \$1.31 million indicates a highly profitable project, as a positive NPV signifies that the project's returns exceed the cost of capital of 10%. Moreover, the payback period of roughly 3.3 years exceeds the company's policy threshold of 3 years. This presents a conflict between the quantitative financial metrics and internal policy constraints.
Acceptance Considerations:
- Based solely on NPV, the project is financially attractive and should be accepted.
- However, the payback policy serves as a risk management criterion, aimed at limiting exposure to long-term investments with delayed returns.
Impact of Additional Investment in Land and Buildings:
If the project required further investments, such as land or additional buildings, the initial outlay would increase correspondingly. For example:
- Additional land/building costs would heighten initial investments, extending the recovery period.
- Given the company's policy of not accepting projects with payback periods exceeding three years, such added investments could render the project unacceptable unless the cash flows significantly increase or the policy relaxes.
In conclusion, the project's strong NPV supports its financial viability, but the payback period criterion criticizes it due to the marginal exceedance. The company's policy underscores the importance of aligning project evaluations with risk appetite and financial thresholds. If investments in land and properties significantly increase the initial outlay, the project's eligibility under the company's payback policy would likely diminish, emphasizing the need for careful evaluation of additional costs and their impact on cash flow timing.
Conclusion
This analysis demonstrates that robust financial metrics like NPV and payback period critically inform project assessments. While the project's high NPV advocates for acceptance, the payback period highlights risk considerations aligned with company policies. Future decision-making should weigh these factors alongside strategic considerations and risk tolerances, especially when additional investments extend payback durations beyond acceptable limits.
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