Gammy is considering building a facility to manufacture cupcakes to distribute nationally. Your

| October 22, 2018

Gammy is considering building a facility to manufacture cupcakes to
distribute nationally. Your assignment
involves both the calculation of cash flows associated with the new investment
under consideration and the evaluation of several mutually exclusive
projects. Grammy wants you to meet with
everyone involved and write a meeting report for the board of directors that
includes your recommendation. In
addition to the recommendation, you have been asked to respond to a number of
questions aimed at understanding the capital-budgeting process. Grammy wants to be sure that she and the
board of directors understand cash flow and capital budgeting.
We are considering constructing a building to manufacture cupcakes. Currently we are in the 34 percent marginal
tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last 5 years and
then, because this is somewhat of a fad product, be terminated. The following information describes the
project:
Cost of new plant and equipment $7,900,000
Shipping and installation costs $100,000
Unit Sales

Year

Units Sold

1

70,000

2

120,000

3

140,000

4

80,000

5

60,000

Sales price per unit $300/unit in years 1 through 4, $260/unit in year 5Variable cost per unit $180/unitAnnual fixed costs $200,000 per year in years 1 – 5
Working-capital requirementsThere will be an initial working-capital requirement of $100,000 just to
get production started. For each year,
the total investment in net working capital will be equal to 10 percent of the
dollar value of sales for that year.
Thus, the investment in working capital will increase during years 1
through 3, then decrease in year 4.
Finally, all working capital is liquidated at the termination of the
project at the end of year 5.
The depreciation methodUse the simplified straight-line method over 5 years. Assume the plant and equipment will have no
salvage value after 5 years.
a. Should you focus on cash flows or
accounting profits in making the capital-budgeting decision? Should you be interested in incremental cash
flows, incremental profits, total free cash flow, or total profits?
b. How does depreciation affect free
cash flow?
c. How do sunk costs affect the
determination of cash flows?
d. What is the project’s initial
outlay?
e. What are the differential cash
flows over the project’s life?
f. What is the terminal cash flow?
g. Draw a cash-flow diagram for this
project.
h. What is its net present value?
I. What is its internal rate of return?
j.Should the project be accepted?
Why or why not?
k.How does Genesis 47 does: 18 – 19
relate to this project and cash flow management?
TUTORIAL PREVIEW d.What is the project’s initial
outlay?
Project’s Initial outlay:

Cost of new plant and equipment

7,900,000

Shipping and installation costs

100,000

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