INTEGRATED CASE

ALLIED FOOD PRODUCTS

Allied Food Products is considering expanding
into the fruit juice business with a new fresh
lemon juice product.

Assume that you were recently hired as

assistant to the director of capital budgeting
and you must evaluate the new project.
The lemon juice would be produced in an unused building
adjacent to Allied’s Fort Myers plant; Allied owns the
building, which is fully depreciated.

The required equipment would cost $200,000, plus an

additional $40,000 for shipping and installation.

In addition, inventories would rise by $25,000, while

accounts payable would increase by $5,000. All of these
costs would be incurred at t = 0.

By a special ruling, the machinery could be depreciated

under the MACRS system as 3-year property. The
applicable depreciation rates are 33%, 45%, 15%, and 7%.
The project is expected to operate for 4 years, at which time it
will be terminated. The cash inflows are assumed to begin 1
year after the project is undertaken, or at t = 1, and to
continue out to t = 4. At the end of the project’s life (t = 4),
the equipment is expected to have a salvage value of $25,000.

Unit sales are expected to total 100,000 units per year, and the
expected sales price is $2.00 per unit. Cash operating costs for
the project (total operating costs less depreciation) are
expected to total 60% of dollar sales. Allied’s tax rate is 40%,
and its WACC is 10%. Tentatively, the lemon juice project is
assumed to be of equal risk to Allied’s other assets.
 You have been asked to evaluate the project
and to make a recommendation as to whether
it should be accepted or rejected.

To guide you in your analysis, your boss gave

you the following set of tasks/questions:
Complete the table using the following steps:
(1) Fill in the blanks under Year 0 for the initial
investment outlay.
(2) Complete the table for unit sales, sales price, total
revenues, and operating costs excluding
depreciation.
(3) Complete the depreciation data.
(4) Complete the table down to after-tax operating
income and then down to the project’s operating
cash flows.
(5) Fill in the blanks under Year 4 for the terminal cash
flows, and complete the project cash flow line.
Discuss working capital. What would have
happened if the machinery had been sold for less
than its book value?
I. Investment Outlay
Equipment ($200.0)
Installation (40.0)
CAPEX
(240.0)
Increase in inventory (25.0)
+
Increase in accounts payable 5.0
NOWC
(20.0)
Total Investment Outlay
(260.0)
II. Project Operating Cash
Y0 Year 1 Year 2 Year 3 Year 4
Flows
Unit sales (thousands) 100 100 100 100
X
Price/unit $ 2.00 $ 2.00 $ 2.00 $ 2.00
Total revenues $200.0 $200.0 $200.0 $200.0
- Operating costs, excluding
$120.0 $120.0 $120.0 $120.0
depreciation
+
Depreciation 79.2 108.0 36.0 16.8
Total costs $199.2 $228.0 $156.0 $136.8
Operating income
= $ 0.8 ($ 28.0) $ 44.0 $ 63.2
before taxes (EBIT)
- Taxes on operating income 0.3 (11.2) 17.6 25.3
= After-tax operating income $ 0.5 ($ 16.8) $ 26.4 $ 37.9
+ Depreciation 79.2 108.0 36.0 16.8
EBIT (1-T) + DEPRECIATION $ 0 $ 79.7 $ 91.2 $ 62.4 $ 54.7
Depreciation
Yr 1 Yr 2 Yr 3 Yr 4
Equipment $ 200 $ 200 $ 200 $ 200
+
Installation 40 40 40 40
= CAPEX 240 240 240 240
x Depreciation Rate - given 33% 45% 15% 7%
Depreciation Expense $ 79.2 $ 108.0 $ 36.0 $ 16.8

The MACRS (Modified Accelerated Cost Recovery System) is

the current system allowed in US in the calculating the
depreciation for depreciable asset. It allows larger deduction in
early years and lower deductions in later years. (compared
to SLM)
III. Project Termination Cash Flows Year 4
Salvage value $ 25.0

+ Tax on salvage value ( 25.0 x 40%) (10.0)

NOWC
+ Increase in Inventory (25)
Increase in Accounts Payable 5 20.0
Project Termination Cash Flows $ 35.0
 Year 0 Year 1 Year 2 Year 3 Year 4

I. Investment Outlay
CAPEX +  NOWC =
Total Investment Outlay (260.0)
II. Project Operating Cash Flows
EBIT (1-T) + DEPRECIATION = $
$ 79.7 $ 91.2 $ 62.4 $ 54.7
Project Operating Cash Flows 0.0
III. Project Termination Cash Flows
Salvage Value (1-T) +  NOWC
= $ 35.0
Project Termination Cash Flows
IV. Project Free Cash Flows

EBIT (1-T) +DEP – (CAPEX +NOWC ($260.0

$ 79.7 $ 91.2 $ 62.4 $ 89.7
) )
 If there is a net increase in the working
capital, this is an outflow (-). At the end of the
project’s life, the firm’s total working capital may
revert to prior levels, the net increase in net
working capital is therefore recovered and
becomes an inflow (+).
 The recovery in the NOWC is equal to the
NOWC. In the problem given, it was stated that
the inventory will increase by $25,000 and the
accounts payable by $5,000. Assuming that all
working capital components will stay the same, the
NOWC is $20,000 at t=0.
 Since the equipment is fully depreciated at
Year 4 (having a book value equal to zero), the
salvage value, the resale value of an asset at the
end of its useful life is a gain on sale of the
equipment sold and so, it is fully taxable and all in
all, will have a net effect on the firm’s net income.
 If the equipment’s book value is not equal to
zero – let’s say, the asset is sold at an amount that
is lower than its BV, then it will incur a loss, and
have a positive tax effect. If sold at an amount
higher than its BV, the difference is considered a
gain, and have a negative tax effect.
 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 in the table should
not be revised to show projected interest charges,
for the effect of using debt in its capital structure is
already incorporated in the cost of capital - WACC.
 It already reflects the impact of interest
charges that is used in calculating the discounted
cash flows.

Hence, it would be inefficient, repetitive and

incorrect to revise the projected cash flows.
 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 $50,000 expenditure that was used to
renovate the building LAST YEAR was a sunk cost.
Therefor, it would not, in any way, affect the
decision and should not be included in the
analysis.
Suppose 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?
 The rental payment is an opportunity cost.
The opportunity cost’s after-tax amount of
$15,000, should be charged to the new project,
and failure to do so would artificially and
incorrectly increase the new project’s NPV.
 Assume that the lemon juice project
would take profitable sales away from
Allied’s fresh orange juice business.

Should that fact be reflected in your

analysis? If so, how?
 This is a negative within-firm externality –
cannibalization. The decrease in sales on Allied's
fresh orange juice business (due to the lemon juice
project) should be reflected in the analysis by
reducing the revenues shown in the analysis by the
amount of decreased revenues for the orange juice
business.
Disregard all the assumptions from Part B,
and assume there is no alternative use
for the building over the next 4 years.
Now calculate the project’s NPV, IRR,
MIRR, and payback. Do these indicators
suggest that the project should be
accepted? Explain.
NET Present Value
•
 IRR
•
MIRR
•
PAYBACK
Year Cash Flows Cumulative Cash
Flows
0 $ (260.0) $ (260.0)
1 79.7 (180.3)
2 91.2 (89.1)
3 62.4 (26.7)
4 89.7 63.0

Payback = 3 years + $26.7/$89.7

= 3.3 years
After computing the project’s NPV, IRR,
MIRR and Payback Period and based on

the different budgeting decision criteria

available to these methods, it evidently
suggest that the project should

NOT BE ACCEPTED.