Gustav is a visionary company in the market for cat food. The company bears the name of its esteemed owner, Gustav Gustavson, a world-renowned financier, and food lover. Combining his two passions (finance and food), Gustav introduced various organic mouthwatering culinary creations inspired by the menus of different Michelin-starred restaurants. The reason was simple: cats deserve the best and nothing less than their human friends.

Gustav is considering expanding his business with a new fresh meat food product. Because Gustav leaves on a business trip, he asked you to evaluate the free cash flows generated by this project and perform several sensitivity analyses. He will make the final decision.

The product will be produced in a building owned by Gustav. The building is fully depreciated, and it is not currently in use. However, Gustav can rent the building to his brother Kasper for $25,000 per year starting next year.

The required equipment would cost $200,000 plus an additional $30,000 in shipping and $10,000 in installation. The machinery could be depreciated under the MACRS system as 3-year property. In addition, inventories would rise by $20,000, while accounts payable would increase by $5,000 and accounts receivables by $5,000. The project is expected to operate for 4 years when it will be terminated. At the end of the project’s life, the equipment is expected to have a salvage value of $25,000.

Unit sales are expected to total 100,000 units per year, and the expected sales price is $2.00 per unit during the first year. The selling price will increase by 3% annually with inflation. Cash operating costs for the project are expected to total 60% of sales.

Gustav expects the new product to take sales away from his existing business. He estimates a loss of $5,000 per year. The company’s tax rate is 40%. Gustav calculated the company’s cost of capital for you. It is 5%

1. Compute the FCFs associated with this project.

2. Using NPV, IRR, and MIRR, what would you advise Gustav? Do you reach the same conclusion using all three capital budgeting criteria?

3. Using the payback method, how long does it take to recoup the initial investment? What if you use the discounted payback method?

You already know that Gustav wants a thorough investigation. Therefore, he wants you to conduct these additional analyses. Consider each analysis independently. Use only NPV and IRR.

a) Perform a sensitivity analysis assuming sales deviate from the base value of 100,000 by plus or minus 10%, 20%, and 30%. How will these changes affect the annual FCFs?

b) What if the cost of capital changes? Perform a sensitivity analysis with the cost of capital varying between 2% and 7%. (Use 1% increments.) What happens with the NPV as cost of capital increases?

c) Combining the sensitivity analysis from Part a (changes in sales) and the cost of capital changes (Part b), what is your recommendation?

d) Gustav spoke with a CPA who can legally reduce the company’s effective tax rate to 30%. How does that change your analysis?

e) Gustav has also conducted a $500,000 market research. He concluded he could charge $3 instead of $2 per unit. How does the market research change the FCFs, and your recommendation? 

Answer rating: 100% (QA)

To evaluate the free cash flows FCFs associated with the new fresh meat food product and perform the requested sensitivity analyses well go through the calculations step by step Lets start with comput... View the full answer