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Answers:
Answer to Question 1:-

The cash flow table for the new lemonade project is prepared below:

Cash Flow Statement:

 

 

 

 

 

 

 

 

Period

 

Particulars

0

1

2

3

4

Total

 

 

 

 

 

 

 

Initial Investment:

 

 

 

 

 

 

Depreciable Cost of Machinery

($550,000)

 

 

 

 

($550,000)

Initial Requirement of Inventory

($60,000)

 

 

 

 

($60,000)

Total Initial Investment

($610,000)

$0

$0

$0

$0

($610,000)

Less: Loan from Bank

$500,000

 

 

 

 

$500,000

Net Initial Investment

($110,000)

$0

$0

$0

$0

($110,000)

Operating Cash Flow:

 

 

 

 

 

 

Sales Volume

$0

$250,000

$250,000

$250,000

$250,000

$1,000,000

Selling Price p.u.

$0

$4.00

$4.20

$4.41

$4.63

 

Annual Sales Revenue

$0

$1,000,000

$1,050,000

$1,102,500

$1,157,625

$4,310,125

Expenses:

 

 

 

 

 

 

Operating Cost p.u.

$0

$2.80

$2.88

$2.97

$3.06

 

Annual Operating Cost

$0

$700,000

$721,000

$742,630

$764,909

$2,928,539

Depreciation on Machinery

$0

$220,000

$165,000

$110,000

$55,000

$550,000

Interest on Loan

$0

$60,000

$60,000

$60,000

$60,000

$240,000

Total Expenses

$0

$980,000

$946,000

$912,630

$879,909

$3,718,539

Net Profit Before Tax

$0

$20,000

$104,000

$189,870

$277,716

$591,586

Less: Income Tax

$0

$6,000

$31,200

$56,961

$83,315

$177,476

Net Profit after Tax

$0

$14,000

$72,800

$132,909

$194,401

$414,110

Add: Depreciation on Machinery

$0

$220,000

$165,000

$110,000

$55,000

$550,000

Less: Change in Inventory Value

$0

$40,000

$5,000

$5,250

$5,513

$55,763

Annual Operating Cash Flow

$0

$194,000

$232,800

$237,659

$243,889

$908,348

Terminal Value:

 

 

 

 

 

 

Repayment of Loan

 

 

 

 

($500,000)

($500,000)

Sale of Machine

 

 

 

 

$10,000

$10,000

Less: Tax on Sales

 

 

 

 

($3,000)

($3,000)

Net Terminal Value

$0

$0

$0

$0

($493,000)

($493,000)

Net Cash Flow from Lemonade Project

($110,000)

$194,000

$232,800

$237,659

($249,111)

$305,348

 
Though cash flow table is very essential for management decision-making purpose, it is an accounting statement. Hence, it is prepared with conservative approach. The cash flow table includes the direct cash inflows and cash outflows from any project. Any kind of cash flows from opportunity cost or revenue are not taken for consideration to prepare cash flow tables. For example, few costs are discussed below:

  1. a) The annual interest expense is directly related to the project, as it would be paid for the loan, taken for the project only. Moreover, it would cause direct cash outflows also. Hence, it would be incorporated in the cash flow table as a part of annual operating expenses (Burns & Walker, 2015).
  2. b) The initial requirement of inventories would increase the total initial investment of the project. The annual requirement of inventories would also create impact on the annual cash flows. Increase in the closing balance of the inventories would decrease the cash balance and vice versa. Hence, both the expenditure items should be considered for cash flow table.
  3. c) As per the case study, the rehabilitation cost of plant was incurred in the previous financial period. It was already adjusted in the previous period’s cash flow table. Hence, it is not accounted further for this purpose.
  4. d) Introduction of new lemonade would result in the fall of sales and operating cost of frozen lemonade. This would surely affect the cash flows of the overall organization. However, as the affect would be reflected in the cash flow tables for frozen lemonades, it should not be included in the cash flow tables of new lemonades.
  5. e) The expected lease rental of plant is a opportunity revenue, which, would not be realized in reality if the new lemonade project would be commenced. Hence, the loss of rental revenue should not be taken into consideration for preparing cash flow tables as per accounting policies (Kashyap, 2014).
Answer to Question 2:-

The capital budgeting process includes all the relevant expenses and cost benefits, which are generated from any project both directly and indirectly. Hence, the capital budgeting analysis of the new lemonade project incorporates the following expenses and cost benefits, which are not considered for the cash flow table:

  • Rehabilitation Cost: Rehabilitation costs might be incurred in the previous period, but the new project cannot be started without the rehabilitation of the plant. Hence, it is a relevant cost for the project (Dellavigna & Pollet 2013).
  • Loss on Profit of Frozen Lemonade: The new project would cause fall in net profit of the frozen lemonade. Therefore, to evaluate the potentiality of the new project, the loss of profits, caused by the project, should also be considered.
  • Loss on Rental Income: If the new project would not be commenced, then the company could earn rental income from the plant. Hence, it should be checked whether the profit from the project is higher from the rental income or not.

On the basis of the above assumptions, the project is measured under different capital budgeting techniques in the table below:

Capital Budget Analysis:

 

Period

 

Particulars

0

1

2

3

4

Total

Initial Investment:

 

 

 

 

 

 

Depreciable Cost of Machinery

($550,000)

 

 

 

 

($550,000)

Rehabilitation Cost of Plant

($80,000)

 

 

 

 

 

Initial Requirement of Inventory

($60,000)

 

 

 

 

($60,000)

Total Initial Investment

($690,000)

$0

$0

$0

$0

($690,000)

Less: Loan from Bank

$500,000

 

 

 

 

$500,000

Net Initial Investment

($190,000)

$0

$0

$0

$0

($190,000)

Operating Cash Flow:

 

 

 

 

 

 

Sales Volume

0

250000

250000

250000

250000

1000000

Selling Price p.u.

$0

$4.00

$4.20

$4.41

$4.63

 

Annual Sales Revenue

$0

$1,000,000

$1,050,000

$1,102,500

$1,157,625

$4,310,125

Expenses:

 

 

 

 

 

 

Operating Cost p.u.

$0

$2.80

$2.88

$2.97

$3.06

 

Annual Operating Cost

$0

$700,000

$721,000

$742,630

$764,909

$2,928,539

Depreciation on Machinery

$0

$220,000

$165,000

$110,000

$55,000

$550,000

Loss on Sale of Other Product

$0

$70,000

$70,000

$70,000

$70,000

$280,000

Reduction of Operating Costs

$0

($48,000)

($48,000)

($48,000)

($48,000)

($192,000)

Loss of Rental Income

$0

$48,000

$24,000

$24,000

$24,000

$120,000

Interest on Loan

$0

$60,000

$60,000

$60,000

$60,000

$240,000

Total Expenses

$0

$1,050,000

$992,000

$958,630

$925,909

$3,926,539

Net Profit Before Tax

$0

($50,000)

$58,000

$143,870

$231,716

$383,586

Less: Income Tax

$0

($15,000)

$17,400

$43,161

$69,515

$115,076

Net Profit after Tax

$0

($35,000)

$40,600

$100,709

$162,201

$268,510

Add: Depreciation on Machinery

$0

$220,000

$165,000

$110,000

$55,000

$550,000

Less: Change in Inventory Value

$0

$40,000

$5,000

$5,250

$5,513

$55,763

Annual Operating Cash Flow

$0

$145,000

$200,600

$205,459

$211,689

$762,748

Terminal Value:

 

 

 

 

 

 

Repayment of Loan

 

 

 

 

($500,000)

($500,000)

Sale of Machine

 

 

 

 

$10,000

$10,000

Less: Tax on Sales

 

 

 

 

($3,000)

($3,000)

Savings from Return of Deposit

 

 

 

 

$24,000

$24,000

Net Terminal Value

$0

$0

$0

$0

($469,000)

($469,000)

Net Cash Flow from Lemonade Project

($190,000)

$145,000

$200,600

$205,459

($257,311)

$103,748

Discount Factor

1

0.8772

0.7695

0.6750

0.5921

 

Discounted Cash Flow

($190,000)

$127,193

$154,355

$138,679

($152,349)

 

Net Present Value

$77,878

 

IRR

34.68%

 

Profitability Index

40.99%

 

Cumulative Cash Flow

($190,000)

($45,000)

$155,600

$361,059

$103,748

 

Payback Period (in years)

1.29

 

 
As per the table, the project would generate positive net present value. The internal rate of return would also be higher than the weighted average cost of capital. It indicates that the company would get higher return from the investments in comparison to the cost of the capital invested. The profitability index states that the project can deliver almost 40% profit over the initial investment. Moreover, the project would be able to return the initial investment within 1.29 years, which is almost half of the expected payback period of the company.

As under all the capital budgeting techniques, the project can be considered as profitable, the company can undertake the project.

Answer to Question 3:-

The break-even point is the particular point of sales, where the totals revenue from the sales and total expenses use to be equal. There would be neither any profit nor any loss at the break-even point. On the other hand, any company can generate net cash inflows from the operating activities if the totals sales revenue would be higher than the total expenses. As in the break-even point, both the sales and expenses would be equal, the project cannot generate any excess cash inflow fat this point (DRURY, 2013). 

If along with the sales volume, the selling price per unit and operating cost per unit would remain unchanged, the break-even sales volume would be as follows:

Break-Even Unit Sales Volume:

Particulars

Amount

Operating Cost p.u.

$2.80

Sales Volume

250000

Total Operating Cost

$700,000

Less: Fixed Cost

$350,000

Variable Cost

$350,000

Variable Cost p.u.

$1.40

Selling Price per unit

$4.00

Contribution Margin per unit

$2.60

Break-Even Unit Sales

134615

Answer to Question 4:-

The NPV of the project for different sales volume is shown in the following table:

Sensitivity Analysis for Change in Sales Volume:

Particulars

NPV

Worst Case

($41,290)

Best Case

$197,046

The NPV of the project for various rate of cost of capital are as follows:

Sensitivity Analysis for Change in Cost of Capital:

Particulars

NPV

Cost of Capital Rate:

 

9%

$88,235

11%

$84,173

12%

$82,097

Actual Rate - 14%

$77,878

16%

$73,597

17%

$71,441

19%

$67,115

 Answer to Question 5:-

The risk of project on the basis of the sales volume is measured in the following table:

Risk Analysis:

Particulars

NPV

Probability

Expected NPV

Worst Case

($41,290)

0.25

($10,322.50)

Most - Lijkely Case

$77,878

0.5

$38,939.12

Best Case

$197,046

0.25

$49,261.50

Project's Expected NPV

 

1

$77,878.12

Standard Deviation

 

 

$31,842.09

Co-Efficient of Variation

 

 

1.23

 Answer to Question 6:-

From the above tables, it can be stated that the NPV of the project is related positively with sales volume and negatively with cost of capital. It is less sensitive to the cost capital. The rise in cost of capital would cause fall in the NPV, but still it would be positive.

However, it is highly sensitive to the sale volume. The table, above, exhibits that in worst-case the NPV would be negative and is best case, it would be quite higher than the most-likely case. Hence, it is necessary to measure the risk, associated with the sales volume.

The table, shown in question 4, suggests that the expected NPV of the project would be same as the NPV for most-likely scenario. However, the coefficient of variation for the project is 1.23. It indicates that the risk level of the project is out of the normal risk range of the company. The difference with higher limit of risk range and the project’s risk level is also quite high. Hence, the project should be classified as project with higher risk (Clancy & Collins, 2014).

Answer to Question 7:-

The expected life of the old machinery is four years and after that, it has to be replaced with new one. Hence, if the company would replace the old machine with the new machine after four years, then the NPV of the project would be same.

However, if the machine is replaced after two years, the NPV would be as follows:

Capital Budget Analysis:

 

Period

 

Particulars

0

1

2

3

4

Total

Initial Investment:

 

 

 

 

 

 

Depreciable of Machinery

($550,000)

 

 

 

 

($550,000)

Rehabilitation Cost of Plant

($80,000)

 

 

 

 

 

Initial Requirement of Inventory

($60,000)

 

 

 

 

($60,000)

Total Initial Investment

($690,000)

$0

$0

$0

$0

($690,000)

Less: Loan from Bank

$500,000

 

 

 

 

$500,000

Net Initial Investment

($190,000)

$0

$0

$0

$0

($190,000)

Operating Cash Flow:

 

 

 

 

 

 

Sales Volume

0

250000

250000

250000

250000

1000000

Selling Price p.u.

$0

$4.00

$4.20

$4.41

$4.63

 

Annual Sales Revenue

$0

$1,000,000

$1,050,000

$1,102,500

$1,157,625

$4,310,125

Expenses:

 

 

 

 

 

 

Operating Cost p.u.

$0

$2.80

$2.88

$2.97

$3.06

 

Annual Operating Cost

$0

$700,000

$721,000

$742,630

$764,909

$2,928,539

Depreciation on Machinery

$0

$220,000

$165,000

$255,000

$178,500

$818,500

Loss on Sale of Other Product

$0

$70,000

$70,000

$70,000

$70,000

$280,000

Reduction of Operating Costs

$0

($48,000)

($48,000)

($48,000)

($48,000)

($192,000)

Loss of Rental Income

$0

$48,000

$24,000

$24,000

$24,000

$120,000

Cost Savings for New Machine

$0

$0

$0

($22,000)

($22,000)

($44,000)

Interest on Loan

$0

$60,000

$60,000

$60,000

$60,000

$240,000

Total Expenses

$0

$1,050,000

$992,000

$1,081,630

$1,027,409

$4,151,039

Net Profit Before Tax

$0

($50,000)

$58,000

$20,870

$130,216

$159,086

Less: Income Tax

$0

($15,000)

$17,400

$6,261

$39,065

$47,726

Net Profit after Tax

$0

($35,000)

$40,600

$14,609

$91,151

$111,360

Add: Depreciation on Machinery

$0

$220,000

$165,000

$255,000

$178,500

$818,500

Less: Change in Inventory Value

$0

$40,000

$5,000

$5,250

$5,513

$55,763

Annual Operating Cash Flow

$0

$145,000

$200,600

$264,359

$264,139

$874,098

Capital Expenditure:

 

 

 

 

 

 

Purchase of New Machine

 

 

($850,000)

 

 

($850,000)

Sale of Old Machine

 

 

$300,000

 

 

$300,000

Tax on Sale

 

 

($90,000)

 

 

($90,000)

Total Capital Expenditure

$0

$0

($640,000)

$0

$0

($640,000)

Terminal Value:

 

 

 

 

 

 

Repayment of Loan

 

 

 

 

($500,000)

($500,000)

Savings from Return of Deposit

 

 

 

 

$24,000

$24,000

Net Terminal Value

$0

$0

$0

$0

($476,000)

($476,000)

Net Cash Flow from Lemonade Project

($190,000)

$145,000

($439,400)

$264,359

($211,861)

($431,902)

Discount Factor

1

0.8772

0.7695

0.6750

0.5921

 

Discounted Cash Flow

($190,000)

$127,193

($338,104)

$178,435

($125,439)

 

Net Present Value

($347,915)

 

 
The table implies that the project would generate negative NPV. Hence, it is recommended that the company should replaced the older machine with the new one after four years.

References & Bibliography:

Andor, G., Mohanty, S. K., & Toth, T. (2015). Capital budgeting practices: a survey of Central and Eastern European firms. Emerging Markets Review, 23, 148-172

Brüggen, A., & Luft, J. L. (2015). Cost estimates, cost overruns, and project continuation decisions. The Accounting Review, 91(3), 793-810

Burns, R., & Walker, J. (2015). Capital budgeting surveys: the future is now.

Clancy, D. K., & Collins, D. (2014). Capital budgeting research and practice: The state of the art. In Advances in Management Accounting (pp. 117-161). Emerald Group Publishing Limited

Dellavigna, S., & Pollet, J. M. (2013). Capital budgeting versus market timing: An evaluation using demographics. The Journal of Finance, 68(1), 237-270

DRURY, C. M. (2013). Management and cost accounting. Springer.

Kashyap, A. (2014). Capital Allocating Decisions: Time Value of Money. Asian Journal of Management, 5(1), 106-110.

Kerler III, W. A., Fleming, A. S., & Allport, C. D. (2014). How framed information and justification impact capital budgeting decisions. In Advances in Management Accounting (pp. 181-210). Emerald Group Publishing Limited

Rossi, M. (2015). The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), 43-56

Zhang, Q., Huang, X., & Zhang, C. (2015). A mean-risk index model for uncertain capital budgeting. Journal of the Operational Research Society, 66(5), 761-770

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