ZXY Company is a food product company. ZXY is considering expanding to two new p

ID: 2411250 • Letter: Z

Question

ZXY Company is a food product company. ZXY is considering expanding to two new products and a second production facility. The food products are staples with steady demands. The proposed expansion will require an investment of $7,000,000 for equipment with an assumed ten-year life, after which all equipment and other assets can be sold for an estimated $1,000,000. They will be renting the facility. ZXY requires a 12 percent return on investments. You have been asked to recommend whether or not to make the investment.

In preparing and supporting your recommendation to either make the investment or not, include the following items as part of your analysis:

Analysis of financial information.

Identification of risks associated with the investment. Consider:

How risky the project appears.

How far off your estimates of revenues and expenses can be before your decision would change.

The difference if the company were to use a straight line versus a MACRS depreciation.

Recommendation for a course of action.

Explanation of criteria supporting your recommendation

FINANCIAL STATEMENTS

ZXY - Forecast Ten Years Pro-Forma Income Statement Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total Brand new Acme System - full system Income Revenue Product A 2,400,000 2,800,000 2,800,000 3,240,000 3,900,000 3,900,000 3,900,000 3,900,000 3,900,000 3,900,000 34,640,000 Product B 900,000 1,350,000 2,500,000 3,000,000 4,000,000 4,950,000 5,500,000 22,200,000 Total · Revenue 2,400,000 2,800,000 2,800,000 4,140,000 5,250,000 6,400,000 6,900,000 7,900,000 8,850,000 9,400,000 56,840,000 Cost of Goods Sold Pest Control 50,000 66,550 73,205 73,205 73,205 73,205 73,205 73,205 73,205 73,205 702,190 SQF FDA mandates 90,000 90,000 90,000 90,000 90,000 30,000 30,000 30,000 30,000 30,000 600,000 Rent - Plant 400,000 408,000 416,160 424,483 432,973 441,632 450,465 459,474 468,664 478,037 4,379,888 Plant Equip. - Fklf - Scrb/Lease 40,000 64,000 64,000 64,000 64,000 64,000 64,000 64,000 64,000 64,000 616,000 Plant Equip. - Ongoing maintenance 50,000 70,000 75,000 75,000 75,000 75,000 75,000 75,000 75,000 75,000 720,000 Plant Equip. - Parts 40,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 490,000 Miscellaneous - Equipment 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 150,000 Building repairs 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 250,000 Plant supplies 100,000 120,000 144,000 109,808 120,789 132,868 146,154 160,770 176,847 194,532 1,405,767 Plant Utilities 120,000 210,000 240,000 240,000 240,000 240,000 240,000 240,000 240,000 240,000 2,250,000 Garbage removal/Janitorial 30,000 45,626 52,470 52,470 52,470 52,470 52,470 52,470 52,470 52,470 495,388 Plant telephone 7,200 7,200 7,200 7,200 7,200 7,200 7,200 7,200 7,200 7,200 72,000 Plant payroll expense 495,000 675,000 825,000 885,000 915,000 975,000 1,005,000 1,065,000 1,095,000 1,125,000 9,060,000 Health Benefits 45,360 97,200 105,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 947,560 WC & P/R Expense 59,400 81,000 99,000 106,200 109,800 117,000 120,600 127,800 131,400 135,000 1,087,200 Installation/Additional Equipment 250,000 - 200,000 - - - - - - - 450,000 Total COGS 1,816,960 2,024,576 2,481,035 2,317,366 2,370,437 2,398,375 2,454,095 2,544,919 2,603,786 2,664,444 23,675,993 Gross Profit 583,040 775,424 318,965 1,822,634 2,879,563 4,001,625 4,445,905 5,355,081 6,246,214 6,735,556 33,164,007 Expenses Other than GOGS Liability Insurance 60,000 91,253 104,940 104,940 104,940 104,940 104,940 104,940 104,940 104,940 990,776 Bank Service Charges 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 15,000 Interest on debt 90,627 187,626 232,323 206,766 166,740 122,959 75,071 31,993 7,539 111 1,121,754 Incentive Plan 13,200 16,500 16,500 16,500 16,500 16,500 16,500 16,500 16,500 145,200 Management 180,000 180,000 180,000 180,000 180,000 190,000 190,000 190,000 190,000 190,000 1,850,000 Workers Comp./P/R Taxes 21,600 21,600 21,600 21,600 21,600 22,800 22,800 22,800 22,800 22,800 222,000 Health Insurance Benefit 4,200 5,082 5,590 5,590 5,590 5,590 5,590 5,590 5,590 5,590 54,004 Office/Administrative Expenses 12,000 15,972 17,569 17,569 17,569 17,569 17,569 17,569 17,569 17,569 168,526 Legal and Professional - Tax 30,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 120,000 Cellular phones 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 50,000 Internet Services 4,400 5,856 6,442 6,442 6,442 6,442 6,442 6,442 6,442 6,442 61,793 Postage & Delivery 1,100 1,464 1,611 1,611 1,611 1,611 1,611 1,611 1,611 1,611 15,448 Office supplies 11,000 9,983 10,981 10,981 10,981 10,981 10,981 10,981 10,981 10,981 108,829 Employee Food & Beverage 1,100 1,464 1,611 1,611 1,611 1,611 1,611 1,611 1,611 1,611 15,448 Local/Business Taxes 1,100 1,464 1,611 1,611 1,611 1,611 1,611 1,611 1,611 1,611 15,448 Property Taxes 12,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 147,000 Travel - Equip. Consultants 25,000 16,500 16,500 16,500 16,500 16,500 16,500 16,500 16,500 16,500 173,500 Licenses and Permits 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 100,000 Total Expense 470,627 592,964 658,777 633,220 593,194 560,613 512,725 469,647 445,193 437,765 5,374,724 Net Income before Depreciation 112,413 182,460 (339,812) 1,189,413 2,286,369 3,441,012 3,933,181 4,885,434 5,801,021 6,297,791 27,789,282 Depreciation Expense ( 185,770 504,140 652,915 573,415 409,635 325,725 299,025 240,970 124,955 33,450 3,350,000 Tax Expense - - - - 99,961 934,586 1,090,247 1,393,339 1,702,820 1,879,302 7,100,255 Net Income (73,357) (321,680) (992,727) 615,998 1,776,773 2,180,701 2,543,909 3,251,125 3,973,246 4,385,039 17,339,027 Forecast of Cash Flows Net Income before Depreciation 112,413 182,460 (339,812) 1,189,413 2,286,369 3,441,012 3,933,181 4,885,434 5,801,021 6,297,791 27,789,282 Deduct startup costs - - - - - - - - - - - Cash flow before income taxes 112,413 182,460 (339,812) 1,189,413 2,286,369 3,441,012 3,933,181 4,885,434 5,801,021 6,297,791 27,789,282 Working Capital - - - - - - - - - - - Lease Payments - Principal 155,146 303,919 401,132 426,689 466,715 510,496 558,384 370,759 149,371 7,389 3,350,001 Pre-Tax Cash Flow (42,733) (121,460) (740,944) 762,725 1,819,654 2,930,516 3,374,796 4,514,674 5,651,651 6,290,402 24,439,282 Taxes - - - - 99,961 934,586 1,090,247 1,393,339 1,702,820 1,879,302 7,100,255 After tax - Cash Flow (42,733) (121,460) (740,944) 762,725 1,719,693 1,995,930 2,284,549 3,121,335 3,948,831 4,411,100 17,339,027

Explanation / Answer

Calculation of Net Present value of investment proposal:

Under MARCS depreciation

Year

After tax cash flows under MACRS dep.

PV factors @12% pa.

Present value of cash flows

1.00

(42,733.00)

0.89

(38,154.46)

2.00

(121,460.00)

0.80

(96,827.17)

3.00

(740,944.00)

0.71

(527,389.30)

4.00

762,725.00

0.64

484,725.53

5.00

1,719,693.00

0.57

975,799.99

6.00

1,995,930.00

0.51

1,011,200.25

7.00

2,284,549.00

0.45

1,033,413.95

8.00

3,121,335.00

0.40

1,260,654.86

9.00

3,948,831.00

0.36

1,423,988.05

10.00

4,411,100.00

0.32

1,420,256.14

Present value of total cash flows

6,947,667.83

Add: Present value of residual value at the end of year 10 (1000000 x 0.321973)

321,973.24

Present value of total cash inflows from the investment

7,269,641.06

Less: Initial investment

7,000,000.00

Net present value (NPV)

269,641.06

As is clear from the above that the investment in the project would result in significant profit for the company as the NPV of the project is positive, i.e. $269,641.06. Thus, the project is relatively less risky. However, in the initial year the company is expected earn negative cash flows is certainly a matter of concern for the company.

Recommendation:

Since the NPV of the investment project is $269,641.06 thus, the company should make the investment. Generally, the investors are mainly concerned about the profitability of a project. In this case the net present value of the investment project shows that the project would help the company to earn positive income over the useful life of the project. Thus, the company should make investment in the project.

No investment project is risk free similarly, the project in this case is also not risk free however, and considering that it is expected to have a positive NPV the project is relatively less risky. Hence, the company should invest in the project.

The depreciation method is an important aspect that affects the eventual cash inflow from a project. In case the company uses straight line method of depreciation the annual depreciation would be as following:

Under Straight line method of depreciation

Annual depreciation would have been

Cost investment

7000000

Less: Residual value

1000000

Depreciable value

6000000

Useful life

10 years

Annual depreciation (6000000/10)

600000

Since, the annual depreciation under SLM is higher than depreciation in MACRS thus, the project would be even more acceptable as the tax liability would be even lower for the company which in turn would increase the cash inflow to the company. Hence, the investment project should be accepted by the company irrespective of the depreciation method used to ascertain the amount of depreciation.

Decision:

The investment of $7,000,000 should be made as the NPV of the investment project is positive.