Part 1 Case study (25 marks)

You are placed in the role of an analyst for Hill Country Snack Food Co. Hill Country Snack Food Co is considering investing in a new product, SuperBar. You have been asked by the CEO to provide a recommendation on whether to go ahead with the investment in SuperBar.

The research and development costs so far have totalled $40 million (exotic superfoods and rare minerals of dubious origin are expensive!). If approved by the CEO, SuperBar could be put on the market at the beginning of next year (Year 1), and Hill Country expects it to stay on the market for a total of four years (from Year 1 to Year 4).

If the project proceeds, the initial investment will occur immediately (Year 0), and operational cash flows will occur at beginning of next year (Year 1). Hill Country must initially invest $1million in production equipment to make the SuperBar (in Year 0). This equipment can be sold for $800,000 at the end of four years (Year 4). Hill Country would sell the SuperBar through its current channels, so sales will be able to commence as soon as the equipment is operational.

SuperBar is expected to wholesale for $2 per bar. The variable cost to produce each bar is $1. In order to secure appropriate celebrity endorsement for the new SuperBar, Hill Country will incur $20 million in marketing and general administration costs in the first year (Year 1). Both selling price and costs (including variable cost and marketing and general administration cost) are expected to increase at the inflation rate in the subsequent years (Year 2 to Year 4). Hill Country's corporate tax rate is 35.5 percent. Annual inflation is expected to remain constant at 3.25 percent over the life of the project.

Industry research suggests the following sales targets are reasonable: 30 million bars sold in the first year, 20 million in year two, 15 million in year three, and 15 million in year four. The production equipment would be depreciated using the straight-line depreciation method over 4 years to a zero balance. The immediate initial working capital requirement is $1 million in Year 0. At the end of Year 4, the company will get all working capital back.

For the purposes of this analysis, assume a 10% discount rate is appropriate.

Please complete the following questions.

1. Calculate the incremental free cash flow during the project's life (starting from Year 0 to Year 4). Show workings. (15 marks)

Year 0

$1million in production equipment

$1 million in initial working capital

Total cash flow = - $2 million in total initial investment

Year 1

Revenue: 30m$2.00=$60m

Variable Costs: 30m$1.00=$30m

Marketing Costs: $20m

Depreciation: $1m/4=$250,000

Taxable Income: $60m$30m$20m$250,000=$9.75m

Tax: $9.75m35.5%=$3.46125m

Net Income: $9.75m$3.46125m=$6.28875m

Cash Flow from Operations:

$6.28875m+$250,000=$6.53875m

Free Cash Flow: $6.53875m

Year 2

Inflation rate: 3.25%

Adjusted Price: $2.00(1+3.25%)=$2.065

Adjusted Variable Cost per Unit: $1.00(1+3.25%)=$1.0325

Revenue: 20,000,000$2.065=$41,300,000

Variable Costs: 20,000,000$1.0325=$20,650,000

Depreciation: $1,000,000/4=$250,000

Taxable Income: $41,300,000$20,650,000$250,000=$20,400,000

Tax (35.5%): $20,400,0000.355=$7,242,000

Net Income: $20,400,000$7,242,000=$13,158,000

Cash Flow from Operations: $13,158,000+$250,000=$13,408,000

Free Cash Flow: $13,408,000

Year 3

Adjusted Selling Price: 2.065(1+0.0325) =$2.1321

Year 3 adjusted cost: 1.0325(1+0.0325)=$1.0657

Sales: 15 million bars

Revenue: 15,000,000$2.1321=$32,001,500

Variable Costs: 15,000,000$1.0657=$15,985,500

Depreciation: $250,000

Taxable Income: $32,001,500$15,985,500$250,000=$15,766,000

Tax (35.5% corporate tax rate): $15,766,0000.355=$5,597,030

Net Income: $15,766,000$5,597,030=$10,168,970

Cash Flow from Operations: $10,168,970+$250,000=$10,418,970

Free Cash Flow: $10,418,970

Year 4

Year 4 adjusted price: 2.1321(1+0.0325)=$2.2006

Year 4 adjusted cost: 1.0657(1+0.0325)=$1.0998

Sales: 15 million bars

Revenue: 15,000,000$2.2006=$33,009,000

Variable Costs:15,000,000$1.0998=$16,497,000

Depreciation: $250,000

Taxable Income: $33,009,000$16,497,000$250,000=$16,262,000

Tax (35.5% corporate tax rate): $16,262,0000.355=$5,772,910

Net Income: $16,262,000$5,772,910=$10,489,090

Cash Flow from Operations: $10,489,090+$250,000=$10,739,090

Salvage Value of Equipment: $800,000

Recovery of Working Capital: $1,000,000

Free Cash Flow: $10,739,090+$800,000+$1,000,000=$12,539,090

1. Calculate the NPV, payback period and IRR of the project. Should the project be accepted based on NPV rule? Show workings and explain your answer(s). (10 marks)

NPV calculation:

NPV= {-2000000/(1+0.10)^0} + {6538750/(1+0.10)^1} + {13408000/(1+0.10)^2} + {10418970/1+0.10}^3} + {12539090/(1+0.10)^4}

NPV=2,000,000+5,944,318+11,079,339+7,829,631+8,564,380

NPV=31,417,668

IRR calculation: how to calculate