Superior Manufacturing is thinking of launching a new product

Superior Manufacturing is thinking of launching a new product. The company expects to sell $950,000 of the new product in the first year and $1,500,000 each year thereafter. Direct costs including labor and materials will be 55% of sales. Indirect incremental costs are estimated at $80,000 a year. The project requires a new plant that will cost a total of $1,000,000, which will be depreciated straight line over the next five years. The new line will also require an additional net investment in inventory and receivables in the amount of $200,000. Assume there is no need for additional investment in building and land for the project. The firm's marginal tax rate is 35%, and its cost of capital is 10%. Based on this information you are to complete the following tasks.

Calculate the payback period, net present value, internal rate of return, and modified rate of return for a proposed capital budgeting project.

Year 0 1 2 3 4 5 6 7
I. Investment Outlay
1. New plant -1,000,000
2. Increase in net working capital -80,000
3. Total net investment -1,080,000

II. Operating Cashflows over the Project's Life
4. Sales of new product 950,000 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000
5. Variable costs (55% of sales) 522,500 825,000 825,000 825,000 825,000 825,000 825,000
6. Indirect cost ($80,000 per year) 80,000 80,000 80,000 80,000 80,000 80,000 80,000
7. Depreciation on new equipment 200,000 200,000 200,000 200,000 200,000 - -
8. Earning before tax 147,500 395,000 395,000 395,000 395,000 595,000 595,000
9. Taxes (35%) 51,625 138,250 138,250 138,250 138,250 208,250 208,250
10. Projected net operating income 95,875 256,750 256,750 256,750 256,750 386,750 386,750
11. Add back noncash expenses (depreciation expense) 200,000 200,000 200,000 200,000 200,000 - -
12. Cash flow from operations 295,875 456,750 456,750 456,750 456,750 386,750 386,750

Straight line depreciation rates for 5 years

Year 1 2 3 4 5

Equipment 20.00% 20.00% 20.00% 20.00% 20.00%

Cost of capital = 10.00%

Calculate the payback period, net present value, internal rate of return, and modified rate of
return for a proposed capital budgeting project.

Net present value

First, we need to find the present value for the total projected cash flow by using the above required rate of return.

Discount factor 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132
Present value of projected cash inflow 268,980 377,458 343,156 311,960 283,596 218,320 198,480

Total present value of projected cash inflow = 2,182,370

NPV = Initial investment + present value of projected cash inflow
NPV = -1,080,000 + 2,182,370
NPV = 1,102,370

Payback period

Payback period is defined as the expected number of years required to recover the original investment.

Period 0 1 2 3 4 5 6 7 8
Net cash flow -1,080,000 295,875 456,750 456,750 456,750 456,750 386,750 386,750 386750
Cumulative NCF -1,080,000 -784,125 -327,375 129,375 586,125 1,042,875 1,429,625 1,816,375 2,203,125

Payback = Year before full recovery + Unrecovered cost at start of year
Cash flow during year

= 2 + 327,375/456,750 = 2.72 years

The project should be accepted because the NPV of the project is positive, and the payback period is less than three years.

If the project required additional investment in land and building, we will need to recalculate the NPV and payback period again because
additional investment in land and building will affect the NPV and payback period.

Internal Rate of Return

The internal rate of return is defined as that discount rate which equates the present value of a project's expected cash inflows to the present
value of the project's costs:

PV(Inflows) = PV(Investment costs),

or the rate which forces the NPV to equal zero.

IRR = 33.47%

Modified rate of return

The modified IRR assumes that all cash flows are reinvested at the firm's cost of capital.

PV(costs) = PV(terminal value),

Discount factor 1.9487 1.7716 1.6105 1.4641 1.3310 1.2100 1.1000
Cash flow -1,080,000 295,875 456,750 456,750 456,750 456,750 386,750 386,750
Terminal value of projected cash inflow 576,572 809,178 735,596 668,728 607,934 467,968 425,425
Total 4,678,150

MIRR = 20.11%

Needed information:
Describe the financial statement forecasting process.

The format of the balance sheet and income statement can be used as a format for planning the next period. This form of planning is
called Pro-Forma financial statements.

In order to prepare the pro-forma financial statements, we can use the Percent of sales method, which simply takes the last available year and uses the balance sheet and income statement to forecast next year by assuming that most items on the statements will have to go up if sales go up. When sales go up, it will also cause the assets in balance sheet
to increase as a result of increase in inventory. In addition, with the increase in asset, the liabilities and equity must also increase. Additional Funds Needed should be calculated.

Explain the importance of the marginal cost of capital (MCC) schedule in financial decision making.

As the firm tries to attract more new dollars, the cost of each dollar will at some point rise. Thus, it is important that the firm understand the marginal cost of capital in order to accept or reject any projects.