Adams Incorporated Wants To Add A New Line Of Business ✓ Solved

Adams Incorporated Would Like To Add A New Line Of Business

Adams, Incorporated would like to add a new line of business to its existing retail business. The new line of business will be the manufacturing and distribution of animal feeds. This is a major capital project. Adams, Incorporated is aware you an in an MBA program and would like you to help analysis the viability of this major business venture based on the following information:

• The production line would be set up in an empty lot the company owns.
• The machinery’s invoice price would be approximately $200,000, another $10,000 in shipping charges would be required, and it would cost an additional $30,000 to install the equipment.
• The machinery has useful life of 4 years, and it is a MACRS 3-year asset.
• The machinery is expected to have a salvage value of $25,000 after 4 years of use.
• This new line of business will generate incremental sales of 1,250 units per year for 4 years at an incremental cost of $100 per unit in the first year, excluding depreciation.
• Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 3% per year due to inflation.
• Net working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 40%, and its overall weighted average cost of capital is 10%.

Required:

1. If the company spent $40,000 last year in the upkeep of the empty lot, should this cost be included in the analysis? Why or why not?
2. Disregard the assumptions in part 1 above. What is the machinery’s depreciable basis? What are the annual depreciation expenses?
3. Calculate the annual sales revenues and costs (other than depreciation).
4. Construct annual incremental operating cash flow statements.
5. Estimate the required net working capital for each year based on sales for the following year. Working capital will be recovered at the end of year 4.
6. Calculate the after-tax salvage cash flow.
7. Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR, Profitability Index (PI), and payback?
8. Can you use the Payback method to decide whether this is a good project or not? Why or why not?
9. Interpret what NPV, IRR, and Profitability Index (PI) mean. Based on your interpretation, do these indicators suggest the new business line should be undertaken?

Paper For Above Instructions

Adams Incorporated's proposal to add a new line of business focused on manufacturing and distributing animal feeds presents an opportunity to assess the viability of this project based on various financial metrics. The company's stance on its feasibility will be considered by addressing the enumerated points required for the analysis.

1. Inclusion of Last Year's Upkeep Cost

The $40,000 expense concerning the upkeep of the empty lot should not be included in the analysis. This cost is considered a sunk cost; it has already been incurred and does not affect future cash flows related to the new project. Business decisions should focus solely on the relevant costs and revenues stemming from the project going forward.

2. Machinery’s Depreciable Basis and Annual Depreciation Expenses

The depreciable basis for the machinery amounts to the sum of its invoice price, shipping, and installation costs:

• Invoice Price: $200,000
• Shipping Charges: $10,000
• Installation Costs: $30,000
• Depreciable Basis = $200,000 + $10,000 + $30,000 = $240,000

Considering that the machinery is classified as a MACRS 3-year asset, the MACRS depreciation rates for years 1, 2, and 3 are 33%, 45%, and 15%. The fourth year will have a final depreciation rate of 7% applied to the remaining basis. The annual depreciation expenses are calculated as follows:

• Year 1: $240,000 * 33% = $79,200
• Year 2: $240,000 * 45% = $108,000
• Year 3: $240,000 * 15% = $36,000
• Year 4: $240,000 * 7% = $16,800

3. Annual Sales Revenues and Costs

Sales revenues and costs are projected to fluctuate over the four-year period based on a 3% annual increase. In the first year, the analysis indicates the following:

• Sales Price per Unit: $200
• Incremental Sales Units: 1,250
• Incremental Cost per Unit: $100
• Sales Revenue = 1,250 units * $200/unit = $250,000
• Sales Revenue Year 1 = $250,000
• Cost Year 1 = 1,250 units * $100/unit = $125,000

Future years require adjusting for the 3% increase:

• Year 2 Sales Revenue = $250,000 * 1.03 = $257,500
• Year 2 Cost = $125,000 * 1.03 = $128,750
• And so on for Years 3 and 4...

4. Annual Incremental Operating Cash Flow Statements

Operating cash flows can be derived by computing Earnings Before Interest and Taxes (EBIT) from the sales revenues, costs, and depreciation, then adjusting for taxes:

• Operating Income = Sales Revenue - Costs - Depreciation
• Tax = Taxes * Operating Income
• Cash Flow = Operating Income - Tax + Depreciation

This analysis proceeds through the years, ensuring to account for the changing revenues, costs, and corresponding taxation effects.

5. Required Net Working Capital (NWC)

To determine NWC, apply the guideline of 12% of projected sales revenues. The NWC calculation is performed for each year, planning for full recovery at the project termination after year four:

• NWC Year 1 = 12% * $250,000 = $30,000
• NWC Year 2 = 12% * $257,500...

6. After-Tax Salvage Cash Flow

The after-tax salvage cash flow at the end of Year 4 accounts for the machinery’s salvage value adjusted for tax implications. The cash flow is determined using:

• After-tax Salvage Flow = Salvage Value * (1 - Tax Rate)

7. Net Cash Flows and Financial Metrics

Upon compiling annual net cash flows guided by the metrics above, it becomes crucial to compute NPV, IRR, Profitability Index (PI), and payback period using the relevant cash flows and the overall weighted average cost of capital of 10%.

8. Payback Method Evaluation

While the payback method can provide insights into liquidity and timeframes for cash recoupment, its limitations must be acknowledged. It does not account for the time value of money, which can skew perceptions of project viability.

9. Interpretation of NPV, IRR, and PI

NPV indicates the value added by pursuing the project, while IRR reflects the expected rate of return, and PI provides a relative profitability measure. An NPV greater than zero, an IRR above the cost of capital, and a PI greater than one suggest that the new business line is favorable for adoption. Therefore, given positive findings from these metrics, the analysis supports moving forward with this initiative.

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