ALLLIED FOOD PRODUCTS

a. Allied has a standard form that is used in the capital

budgeting process. Part of the table has been completed, but
you must replace the blanks with the missing numbers.
Complete the table using the following steps:
1. Fill in the blanks under the Year 0 for the initial outlays:
CAPEX and change in NOVC.
i. Installation $40,000
ii. Increase in accounts payable $5,000
iii. Change in NOWC
2. Complete the table for unit sales, sales price, total
revenues, and operating costs excluding depreciation.
i. Price/unit (t=3) = $2.00
ii. Price/unit (t=4) = $2.00
iii. Total revenues (t=1) = $200.00
iv. Total revenues (t=2) = $200.00
v. Total revenues (t=3) = $200.00
3. Complete the depreciation data.
i. Year 1
0.33 x $240 = $79.2
Year 2
0.45 x $240 = $108.0
Year 3
0.15 x $240 = $36.0
Year 4
0.07 x $240 = $16.8
4. Complete the table down to after-tax operating income
and then down to the projects operating cash flow,
EBIT(1-T) = DEP.
i. Year 1
$0.5
Year 2
($16.8)
Year 3
$26.4
Year 4
$37.9
5. Fill in the blanks under Year 4 for the terminal cash flows
and complete the project cash flow line. Discuss the
recovery of net operating working capital. What would
have happened if the machinery were sold for less than
its book value?
The net operating working capital requirement is
recovered at the end of Year 4 and the savage value is
fully taxable, as the asset has been depreciated to a
zero book value. If the machinery were sold for less than
its book value, the tax effect could be positive.
b.
1. Allied uses debt in its capital structure, so some of the
money used to finance the project will be debt. Given
this fact, should the projected cash flows be revised to
show projected interest charges? Explain.
The projected cash flows should not be revised to show
interest charges. This is because the debt financing

affected would be reflected in the cost of capital used to

discount
the
cash
flows.
2. Suppose you learned that Allied had spent $50,000 to
renovate the building last year, expensing these costs.
Should this cost be reflected in the analysis? Explain.
The cost should not be reflected in the analysis as it is a
sunk cost that would not affect the decision.
3. Supposed you learned that Allied could lease its building
to another party and earn $25,000 per year. Should that
fact be reflected in the analysis? If so, how?
Yes, it should be reflected in the analysis as the rental
payment is an opportunity cost. Its After-Tax Amount is
$25,000(1 - T) = $25,000(0.6) = $15,000 and should be
subtracted from the companys cash flows.
4. Assume that the lemon juice project would take
profitable sales away from Allieds fresh orange juice
business. Should that fact be reflected in your analysis?
If so, how?
Yes, that fact should be reflected in the analysis as it
shows decrease in sales. The orange juice business cash
flows would be affected by the lemon juice project. The
revenues of the lemon juice project needs to be reduced
by the amount of decreased revenues for the orange
juice business because the lemon juice project will be
taking business away from the orange juice business.
c. Disregard all the assumptions made in Part b and assume
there is no alternative use for the building over the next 4
years. Now calculate the projects NPV, IRR, MIRR and
payback. Do these indicators suggest that the project should
be accepted? Explain.
d. If this project had been a replacement rather than an
expansion project, how would the analysis have changed?
Think about the changes that would have to occur in the cash
flow table.
e.
1. What three levels, or types, of project risk are normally
considered?
2. Which type is most relevant?
3. Which type is easiest to measure?
4. Are the three types of risk generally high correlated?
f.
1. What is sensitivity analysis?
2. How would you perform a sensitivity analysis on the unit
sales, salvage value and WACC for the project? Assume
that each of these variables deviates from its base-case,

or expected, value by plus or minus 10%, 20% and 30%.

Explain how would you calculate the NPV, IRR, MIRR and
payback for each case; but dont do the analysis unless
your instructor asks you to.
3. What is the primary weakness of sensitivity analysis?
What are its primary advantages?
g. Unrelated to the lemon juice project, Allied is upgrading its
plant and must choose between two machines that are
mutually exclusive. The plant is highly successful, so
whichever machine is chosen will be repurchased after its
useful life is over. Both machines cost $50,000; however,
Machine A provides after-tax savings of $17,500 per year for 4
years, while Machine B provides after-tax savings of $34,000
in Year 1 and $27,500 in Year 2.
1. Using the replacement chain method, what is the NPV of
the better machine?
2. Using the EAA method, what is the EAA of the better
machine?
Work out quantitative answers to the remaining questions only if
your instructor asks you to. Also note that it will take a long time to
do the calculations unless you are using an Excel model.
h. Assume that inflation is expected to average 5% over the next
4 years and that this expectation is reflected in the WACC.
Moreover, inflation is expected to increase revenues and
variable costs by this same 5%. Does it appear that inflation
has been dealt with properly in the initial analysis to this
point? If not, what should be done and how would the required
adjustment affect the decision?
i. The expected cash flows, considering inflation (in thousands of
dollars), are given in Table IC 13.2. Allieds WACC is 10%.
Assume that you are confident about the estimates of the
variables that affect the cash flows except unit sales. If
product acceptance is poor, sales would be only 75,000 units
a year, while a strong consumer response would produce sales
of 125,000 units. In either case, cash costs would still amount
to 60% of revenues. You believe that there is a 25% chance of
poor acceptance, a 25% chance of excellent acceptance, and
a 50% chance of average acceptance (the base case). Provide
numbers only if you are using a computer model.
1. What is the worst-case NPV? The best-case NPV?
2. Use the worst-case, most likely case (or base-case), and
best-case NPVs with their probabilities of occurrence, to
find the projects expected NPV, standard deviation, and
coefficient of variation.
j. Assume that Allieds average project has a coefficient of
variation (CV) in the range of 1.25 to 1.75. Would the lemon

juice project be classifies as high risk, average risk, or low

risk? What time of risk is being measured here?
k. Based on common sense, how highly correlated do you think
the project would be with the firms other assets? (Give a
correlation coefficient or range of coefficients, based on your
judgement.)
l. How would the correlation coefficient and the previously
calculated standard deviation combine to affect the projects
contribution to the corporate, or within-firm, risk? Explain.
m. Based on your judgment, what do you think the projects
correlation coefficient would be with the economy affect the
projects market risk?
n. Allied typically adds or subtracts 3% to its WACC to adjust for
risk. After adjusting for risk, should the lemon juice project be
accepted? Should any subjective risk factors be considered
before the final decision is made? Explain.