Jim plans to retire from professional practice and cease all business activities nine years from now.

The plan for the garden tool is to produce and sell it for eight years and then sell the patent and production rights to a national company. Jim has negotiated a tentative lease on a building that is well suited for the manufacturing process. The building must be remodeled to meet the manufacturing needs, and then it must be restored to its original configuration at the end of the eight year lease. At that time, Jim will be able to sell some of the non-specialized equipment for small salvage values. Building remodeling and new equipment purchases will require a front-end investment of $2,700,000. An additional $210,000 in working capital will be required for business operations. Estimated annual cash receipts from tool sales are predicted at $3,200,000 per year for the first three years, $3,600,000 per year for 4 through 6, and $3,800,000 during the last two years of operation. Estimated cash expenses for materials, salaries, supplies, utilities, and other cash expenses are projected at $2,500,000 per year for the first three years, $2,800,000 per year for years 4 through 6, and $3,200,000 per year for the last two years. The remodeling and equipment costs will be capitalized and depreciated over the eight-year period at the rate of $330,000 per year. Realizable salvage value from disposing of the equipment at the end of the eight years is estimated at approximately $60,00. The cost of restoring the building to its original configuration at that time is estimated at $120,000. The working capital tied up in this project will become available for other types of investments at the end of the eight-year period. Jim has asked you to assume a combined federal and state income tax rate of 30% throughout the life of the project and 12% applicable weighted average cost of capital.

Task: (Input in attached spreadsheet) 1. Calculate the net cash flow that should be used for each year in the discounted cash flow analysis 2. Calculate the net present value (NPV) of this project using a discount rate equal to the companys weighted average cost of capital. Round all dollar amounts to the nearest whole dollar. 3. Calculate the expected yield on the project using the discounted cash flow internal rate of return (IRR) method. Round all dollar amounts to the nearest whole dollar. 4. Calculate the accounting rate of return for this project. 5. Calculate the unadjusted payback period. State your answers in years and months. Task: (Input on this document or on a tab in the spreadsheet) Each of these require a sentence or two response. Nothing formal or structured. I will be inputting these into a presentation! 1. Identify what the correct net cash flow for the second year would be if all cash expenses were as described in the scenario but there were no depreciation expenses. Explain the impact of depreciation on the net cash flow for the second year. 3200000-2500000 = 700000 *.7 = 490000 would be the cash flow. The depreciation has provided a tax shield which is equal to 30% of 330000 = 99000. So the cash flow would lower by this amount. 2. Based upon the NPV analysis in Part 2 (above) make a recommendation to Jim regarding what decision to make and why. The project should be undertaken as the present value of all inflows is more than the present value of all outflows.
3. Based upon the IRR analysis in Part 3 (above) make a

recommendation to Jim regarding what decision to make and why. The project should be undertaken as the IRR is higher than the cost of capital which is 12% 4. Explain why the accounting rate of return of this project is different from the internal rate of return from the same capital investment.

Because the ARR is based on profit while IRR is based on present value of cash flows ARR does not consider time value of money while IRR considers it. 5. Explain the relative significance of the unadjusted payback period of this decision situation. Payback period helps in determining that the payback period is within the life of the project otherwise if it would be more than 8 years the NPV would be negative. However the payback period may not be used to decide about project acceptance or rejection as it does not consider time value of money and it also ignores the cash flow generation after the payback period over the life of the project. 6. Explain how the weighted average cost of capital should be used in capital budgeting analysis when utilizing the NPV method. It should be used as discount rate to discount all cash flows during the life of the project. 7. Explain how the weighted average cost of capital should be used in capital budgeting analysis when utilizing the IRR method. The IRR should be compared with WACC to determine whether the project should be undertaken or not and if IRR is more than WACC it should be undertaken otherwise not.