Madison Bakery is considering the installation of a new oven. Made in Milan, the

Question

Madison Bakery is considering the installation of a new oven. Made in Milan, the oven would enable Madison to produce Old World breads which could be sold at premium prices.
Costs are estimated as follows: Milano Oven...$1,150,000 Building Improvements...$650,000 Additions to Working Capital...$100,000
Madison Bakery's WACC is 7% and its tax rate is 30%. Assume straight-line depreciation, and a five-year life for the oven with no salvage value.
EBIT estimates are as follows: $150,000 (Year 1); $175,000 (Year 2); $200,000 (Year 3); $225,000 (Year 4); $250,000 (Year 5).
Draw and submit a time line, including EBIT, taxes, depreciation, operating cash flow, tvm factors, and discounted cash flow.
24. Is the "addition to working capital" a depreciable item ? Why, or why not ?
25. What is the project's present value ?
26. What is the project's NPV ?
27. What is the Payback Period, in years, using non-discounted operating cash flows ?
28. Based on your work, should Madison Bakery proceed with this proposed oven ? Briefly cite why, or why not.

Explanation / Answer

24. Working capital is the fund needed to operate a facility before revenue becomes available for covering expenses. Addition to working capital can happen throughout the life cycle. Addition to working capital sometimes get freed after certain period that is why it is not a depreciable item. 25. Annual depreciation = ($1,150,000+ $650,000)/5 = $360,000 Cash flow for year 1= $150,000*(1-30%) + $360,000 = $465,000 Cash flow for year 2= $175,000*(1-30%) + $360,000 = $482,500 Cash flow for year 3= $200,000*(1-30%) + $360,000 = $500,000 Cash flow for year 4= $225,000*(1-30%) + $360,000 = $517,500 Cash flow for year 5= $250,000*(1-30%) + $360,000 = $535,000 project's present value = $465,000/1.07 + $482,500/1.07^2 + $500,000/1.07^3 + $517,500/1.07^4 + $535,000/1.07^5 = $2,040,408.44 26. Project's NPV =- $1,150,000 -$650,000 -$100,000 +$2,040,408.44 = $140,408.44 27. Initial investment =- $1,150,000 -$650,000 -$100,000 = -$1,900,000.00 Amount recovered in first 3 years = $1,447,500 Payback period = 3 + ($1,900,000.00-$1,447,500)/$517,500 = 3.87 years

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