After graduating from Suffolk University with a finance degree, you have been hi

Question

After graduating from Suffolk University with a finance degree, you have been hired by &J; Bagel, Inc. in its finance department. The company contemplates entering the business of high-end wedding cakes. In 2013 more than 300,000 couples had their weddings in the Northeast region of the U.S. and a wedding cake was a must-have item in virtually all of these weddings. Wedding cakes come in all shapes and sizes and are priced between $200 to $1,000 each. John Benson and Jerry Chen, the owners of J&J; Bagel, hope to capture a large portion of the lucrative wedding cake market in the Northeast region and need to perform a financial analysis to determine the suitability of this business project. J&J; Bagel has already spent $75,000 to create a large catalog of 300 different wedding cakes to be offered to potential clients. The company has spent a further $20,000 for a marketing study to determine the expected sales figures for the wedding cakes. J&J; Bagel can produce wedding cakes for $215 each in variable costs. This is an average figure; variable costs per wedding cake can be higher or lower depending on the type and the size of the wedding cake. Fixed costs for the operation are estimated to run $4.3 million per year. The estimated sales volume is 80,000 wedding cakes per year for the next five years. The average price per wedding cake will be S500. The necessary equipment can be purchased for $32.5 million and will be depreciated on a seven-year MACRS schedule (see Table 1). It is believed the salvage value of the equipment in five years will be $3 5 million. Investment in net working capital (inventories of raw materials, etc.), which is expected to be 20 percent of total annual sales, will occur in Year 0This net working capital will be recovered in Year 5 when the project is terminated. J&J; Bagel has a 35 percent corporate tax rate and a 12 percent required return. MACRS Fixed Annual Depreciation Percentages for 7-year Asset Class ear 2 3 4 6 7 ercentage 14.3% 24.5% 17.5% 12.5% 8.9% 8.9% 8.9% 4.5% John Benson has asked you to prepare a report that answers the following questions: QUESTIONS 1. What is the payback period of the project? 2. What is the NPV of the project? 3. What is the IRR of the project? 4. What is the profitability index of the project? 5. What will happen to the project NPV if the unit price increases by 10%? 6. What will happen to the project NPV if the salvage value of equipment increases by 10%? Should J&J; Bagel undertake this project? 7.

Explanation / Answer

Preparation of Cash flow from the project -

1. Payback period = completed year + remaining amt./ Avaialble Amt.

= 2 + (-12131500) / (-12131500-1884125)*12

= 2 years and 10.38 months

2. NPV = sum of all present value cash flow

= 15846830

3. IRR = 25.59% (can calculate over excel/ by interpolation)

4. Profitability Index = PVCI / PVCO

= 56441830 / 40595000

= 1.39

5. If unit price increase by 10% then NPV would be as follows -

6. If salvage value increased by 10% then salvage value would be = 3.5*1.10 = 3.85 million

Note - Tax on salvage value would not be levied as it slavage value is under cost not above cost.

all values are in $.

Please comment in case of any query.

7. Yes J&J bagel should undertake this project as it has positive NPV.

MACRS Dep. rate 14.30% 24.50% 17.50% 12.50% 8.90% NPV Avg. Cakes sale per year 80000 80000 80000 80000 80000 Year 0 1 2 3 4 5 Catalog cost 75000 marketing study 20000 Equipment cost 32500000 working capital 8000000 Average sales value @ 500 40000000 40000000 40000000 40000000 40000000 less Avg. Variable cost @ 215 17200000 17200000 17200000 17200000 17200000 Contribution 22800000 22800000 22800000 22800000 22800000 less fixed cost 4300000 4300000 4300000 4300000 4300000 EBIDT 18500000 18500000 18500000 18500000 18500000 less Depriciation 4647500 7962500 5687500 4062500 2892500 EBIT 13852500 10537500 12812500 14437500 15607500 less Tax 4848375 3688125 4484375 5053125 5462625 EAT 9004125 6849375 8328125 9384375 10144875 add Depriciation 4647500 7962500 5687500 4062500 2892500 add working capital 8000000 add salvage value 3500000 Net Cash Flow -40595000 13651625 14811875 14015625 13446875 24537375 PV Factor @12% 1 0.8928571 0.7971939 0.71178 0.635518 0.567427 Present Value -40595000 12188951 11807936 9976045 8545732 13923166 15846830 Cum. net cash flow -40595000 -26943375 -12131500 1884125

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