Capital Budgeting Analysis

Part 1: Capital Budgeting Analysis

Adams, Incorporated would like to add a new line of business to its existing retail business. The new line of business will be the manufacturing and distribution of animal feeds. This is a major capital project. Adams, Incorporated is aware you an in an MBA program and would like you to help analysis the viability of this major business venture based on the following information:

• The production line would be set up in an empty lot the company owns.
• The machinery’s invoice price would be approximately $200,000, another
• The machinery has useful life of 4 years, and it is a MACRS 3-year asset.
• The machinery is expected to have a salvage value of $25,000 after 4 years of use.
• This new line of business will generate incremental sales of 1,250 units per year for 4 years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 3% per year due to inflation.
• Net working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 40%, and its overall weighted average cost of capital is 10%.

$10,000 in shipping charges would be required, and it would cost an additional

$30,000 to install the equipment.

Required:

• If the company spent $40,000 last year in the upkeep of the empty lot, should this cost be included in the analysis? Why or why not?
• Disregard the assumptions in part 1 above. What is the machinery’s depreciable basis? What are the annual depreciation expenses?
• Calculate the annual sales revenues and costs (other than depreciation).
• Construct annual incremental operating cash flow statements.
• Estimate the required net working capital for each year based on sales for the following year. Working capital will be recovered at the end of year 4.
• Calculate the after-tax salvage cash flow.
• Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR, Profitability Index (PI), and payback?
• Can you use the Payback method to decide whether this is a good project or not? Why or why not?
• Interpret what NPV, IRR, and Profitability Index (PI) mean. Based on your interpretation, do these indicators suggest the new business line should be undertaken?

Part 2: Working Capital Management

1. Adams Stores, Inc. is trying to determine the effect of its inventory turnover ratio and days sales outstanding (DSO) on its cash flow cycle. Adams’ sales last year (all on credit) were
   • Calculate Adams’ cash conversion cycle
   • Calculate assets turnover and return on assets (ROA)
   • As one of the managers at Adams Stores, Inc, you believe the annual inventory turnover can be raised to 9 times without affecting sales. What would Adams’ cash conversion cycle, total assets turnover, and ROA have been if the inventory turnover had been 9 for the year?
2. Assume the company work for reported sales of $10 million and an inventory turnover of 2. The company is now adopting a new inventory system as part of its working capital management. If the new system is able to reduce the company’s inventory level and increase inventory turnover ratio to 5 while maintaining the same level sales, how much cash will be freed up as a result of the new inventory system.
   • The terms “irrelevance,” “bird-in-the-hand,” and “tax preference” have been used to describe three major theories regarding the way dividend payouts affect a firm’s value. Explain what these terms mean, and briefly describe each theory.
   • What do the three theories indicate regarding the actions management should take with respect to dividend payout?
   • What are stock repurchases? Discuss the advantages and disadvantages of a firm’s repurchasing its own shares.
   • What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and stock splits?

$150,000, and it earned a net profit of 6%. It turned over inventory 7.5 times, during the year and its DSO was 36.5 days. Its annual cost of goods sold was $121,667. The company had fixed assets totally $35,000. Adams’ payable deferral period is 40 days.

Part 3: Dividend Policy:

Assume that you were recently hired by a national consulting firm, which has been asked to help Adams, Stores, Inc. prepare for its public offering. Prepare a presentation in which you review the theory of dividend policy and discuss the following:

Part 4: International Financial Management

Citrus, Inc. is a medium-sized producer of citrus juice drinks in Florida. Until now, the company has confined its operations and sales to the United States, but its CEO, Heidi Sims, wants to expand into Europe. The first step would be to set up sales subsidiaries in Spain and Sweden, then to set up a production plant in Spain, and, finally, to distribute the product throughout the European Union. The firm’s financial manager, George Benson, is enthusiastic about the plan, but he is worried about the implications of the foreign expansion on the firm’s financial management process. He has asked you, the firm’s most recently hired financial analyst, to develop a 1-hour tutorial package that explains the basics of multinational financial management. The tutorial will be presented at the next board of director’s meeting. To get you started, Benson has supplied you with the following list of questions.

• What is a multinational corporation? Why do firms expand into other countries?
• Discuss at least six major factors which distinguish multinational financial management from financial management as practiced by a purely domestic firm. (Please consider doing additional research on this question and document your findings).
• Discuss exchange rate risk as they relate to multinational corporations.
• Describe the current International Monetary System. How does the current system differ from the system that was in place prior to August 1971? (Please consider doing additional research on this question and document your findings).
• What is the difference between spot rates and forward rates? When is the forward rate at a premium to the spot rate? At a discount? (Please consider doing additional research on this question and document your findings).
• From a managerial point of view, discuss how your responses above will help Citrus, Inc. as they plan to expand overseas.