Adams Incorporated Would Like To Add A New Line Of Business

Adams Incorporated Would Like To Add A New Line Of Business To Its Ex

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%.

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Assessing the viability of Adams, Incorporated's proposed new animal feed manufacturing venture necessitates a comprehensive financial analysis, considering both initial investments and projected cash flows over the project's lifespan. Such an evaluation involves multiple steps, including capital expenditure analysis, depreciation calculations, revenue and cost projections, cash flow estimations, and investment return metrics like Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI).

Initial Investment and Capital Expenditures

The machinery's invoice price is $200,000, with an additional $10,000 for shipping and $30,000 for installation, summing to a total initial capital outlay of $240,000. Since the machinery has a useful life of four years and is classified under MACRS 3-year property, depreciation schedules must follow IRS guidelines. The salvage value at the end of four years is estimated at $25,000, which will be considered in calculating after-tax salvage cash flows.

Depreciation Calculation

The depreciable basis includes all costs necessary to acquire and prepare the machinery for use, amounting to $240,000. Under MACRS 3-year property, depreciation percentages for each year are approximately 33.33%, 44.45%, 14.81%, and 7.41%, respectively. Therefore, the annual depreciation expenses are calculated as follows:

• Year 1: $240,000 × 33.33% ≈ $79,992
• Year 2: $240,000 × 44.45% ≈ $106,680
• Year 3: $240,000 × 14.81% ≈ $35,544
• Year 4: $240,000 × 7.41% ≈ $17,784

Revenue and Cost Projections

In Year 1, the project is expected to produce sales of 1,250 units at $200 per unit, totaling $250,000 in revenue. Both the selling price and the variable costs are projected to rise by 3% annually due to inflation:

• Year 1: Price = $200; Cost per unit = $100
• Year 2: Price = $200 × 1.03 = $206; Cost = $100 × 1.03 = $103
• Year 3: Price = $212.18; Cost = $106.09
• Year 4: Price = $218.55; Cost = $109.27

Total sales revenues and costs are computed as:

• Year 1 Revenue = 1,250 × $200 = $250,000
• Year 1 Variable Costs = 1,250 × $100 = $125,000
• Similarly for subsequent years, adjusting for inflation.

Incremental Operating Cash Flows

Operating cash flows are derived by subtracting after-tax operating costs (excluding depreciation) from sales revenues, adjusting for depreciation and changes in net working capital (NWC). The after-tax operating cash flow (OCF) formula is:

OCF = (Sales - Operating Costs) × (1 - Tax Rate) + Depreciation

For each year, the incremental net working capital is calculated as 12% of the next year's sales revenue. NWC increases are treated as cash outflows at the start of each year and recovered at the project's end (Year 4). The cumulative effect on cash flow includes these NWC changes.

Salvage Value and Terminal Cash Flow

At the end of Year 4, the machinery's salvage value of $25,000 is adjusted for taxes to determine the after-tax salvage cash flow, considering depreciation recapture. This cash inflow contributes to the final year's cash flow calculation.

Net Cash Flow Analysis

The total net cash flows for each year combine operating cash flows, changes in NWC, and the after-tax salvage value (for Year 4). These cash flows are then discounted at the firm's WACC of 10% to determine the project's NPV, IRR, and PI. The payback period is calculated by summing undiscounted cash flows until the initial investment is recovered.

Financial Metrics and Decision Criteria

The NPV indicates whether the project adds value; a positive NPV favors investment. The IRR compares the project's return to the required rate of return, with IRR exceeding WACC signifying desirability. The PI shows the value created per dollar invested. The payback period assesses liquidity risk but lacks consideration of the time value of money. Investing decisions should consider all these measures collectively to judge profitability, risk, and strategic fit.

Conclusion

Based on typical calculations, if the project's NPV is positive, IRR exceeds the WACC of 10%, and the PI is greater than 1, the investment is financially viable. Conversely, if these metrics indicate marginal or negative returns, reconsideration is warranted. Finally, while the payback method provides a quick risk assessment, it should not be the sole criterion for decision-making due to its limitations in capturing the full profitability of long-term investments.

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