Evaluation Of The Fresh Lemonade Project Essay.

1. Prepare the cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) for the fresh lemonade project based on the most likely annual sales quantity of 250,000 cartons. For simplicity, assume no other cash flows apart from the sales price and cash operating costs are affected by inflation. Explain if each of the following items should be included in the cash flow statement:  a) The interest expenses on the machinery cost financed by a 12% term loan over four years;  b) Initial investment of $50,000 on inventories and 10% of annual sales revenue in subsequent years;  c) The $80,000 that was spent to rehabilitate the plan;  d) The reduction in Wellness’s frozen lemonade sales and associated production costs;  e) Opportunity of leasing the lemonade production site for $24,000 per year.  
 
2. Consider all information given in the case and Question 1, what are the payback period, net present value (NPV), internal rate of return (IRR) and profitability index (PI) of this project? Assume the company uses a payback rule with cut-off period of three years. Should the project be undertaken based on each of the investment evaluation methods?  
 
3. Assume the sales quantity estimate remains at 250,000 cartons per year, what is the break-even annual net cash inflow for the project? Now assume that the sales price remains at $4.00, and the fixed and variable operating costs are fixed at $2.80 per carton. What annual unit sales volume would be needed for the project to break even? [You may ignore the effects of inflation and tax savings on depreciation.]   
 
4. Show a sensitivity analysis of NPV to sales quantity and cost of capital. Assume each of these variables can deviate from its expected value by plus or minus 20%.  
 
5. Use the worst-, most-likely- and best-case NPVs (i.e. the figures derived in Questions 2 and 4), and their probabilities of occurrence to find the project’s expected NPV, standard deviation, and coefficient of variation.  
 
6. Assess the risk of the fresh lemonade project using the results derived in Questions 3, 4 and 5. Would the project be classified as high risk, average risk, or low risk? Explain.  
 
7. If the fresh lemonade project is a success, should Wellness replace the used machinery in two years’ or four years’ time under normal market condition (i.e. based on annual sales quantity of 250,000 cartons)? Justify your answer. Assume the company is able to acquire the new machinery on the same terms indefinitely, other replacement options are to be ignored, and all revenue and cost figures remain the same.

Cash flow Table

In this report, an attempt is made to analyses the project using the NPV, IRR, payback period and Profitability index. The report also analyses the sensitivity of the projects using different techniques. The main aim of the report is to evaluate and suggest the projects.

Statement showing Cash Flow
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
Initial Investments
Machinery cost	$  550,000.00
Increase in Working capital	$    60,000.00
Rehabilitation expenses	$    80,000.00
Initial Investment	$  690,000.00
Operating Cash Flow
Sales		$        1,000,000.00	$     1,050,000.00	$ 1,102,500.00	$ 1,157,625.00
Savings in cost		$             48,000.00	$          48,000.00	$      48,000.00	$      48,000.00
Total Revenue		$        1,048,000.00	$     1,098,000.00	$ 1,150,500.00	$ 1,205,625.00
Expenses
Variable costs		$           350,000.00	$        371,000.00	$    392,630.00	$    414,908.90
Fixed costs		$           350,000.00	$        350,000.00	$    350,000.00	$    350,000.00
Depreciation		$           216,000.00	$        162,000.00	$    108,000.00	$      54,000.00
Decrease in lemonade concentrate sale		$             70,000.00	$          70,000.00	$      70,000.00	$      70,000.00
Total Expenses		$           986,000.00	$        953,000.00	$    920,630.00	$    888,908.90
Net Profit		$             62,000.00	$        145,000.00	$    229,870.00	$    316,716.10
Tax @30%		$            (18,600.00)	$        (43,500.00)	$    (68,961.00)	$    (95,014.83)
Profit After Tax		$             43,400.00	$        101,500.00	$    160,909.00	$    221,701.27
Add back:
Depreciation		$           216,000.00	$        162,000.00	$    108,000.00	$      54,000.00
(Increase)/decrease in Inventory		$            (40,000.00)	$          (5,000.00)	$      (5,250.00)	$      (5,512.50)
Net cash flow from operation		$           219,400.00	$        258,500.00	$    263,659.00	$    270,188.77
Terminal cash flow (salvage value)					$      10,000.00

Table 1: Cash Flow

(Source: Created by Author) 

a) The loan amount is taken for financing the project machinery. The cash received from loan is not included in the cash flow statement that is prepared for evaluating the project. Hence, as the amount of loan is not included so the interest expenses that is incurred for the loan is also not included in the statement of cash flow (Cole, 2013). 

b)The new project requires increase in initial investment in inventory by $60000. The increase in working capital is a cash outflow and it should be included in the cash flow statement. Therefore, the initial increase in inventory should be included as initial investment in the statement of cash flow. It is provided that there after the inventory level is to be maintained @10% of sales. This will result in difference in inventory and that should be included in the operating cash flow (Harrison 2013).

c) The amount paid for rehabilitation of plant should be included in the cash flow. The main reason for including it in the initial investment is that it is a necessary expenditure that have to be incurred for the projects. 

d) The reduction in the sale of Wellness’s frozen lemonade means that the company will not receive the cash that it would have received on sale. The non-receipt of cash from the sales is equivalent to the cash out flow. Therefore, this should be included as cash outflow from the operating activity. The expenses that has not been incurred as a result of this project should be included as cash flow statement as saving of expenses (Belghitar & Khan, 2013). 

e)The revenue that can be gained from leasing of the production site represents the opportunity cost. There is no effect on cash because of this transaction so this should not be included in the cash flow statement. This opportunity cost will be used at the time of evaluating the projects.

Statement showing NPV, IRR and Cash flow
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Total
Net Cash flow		$           219,400.00	$        258,500.00	$    263,659.00	$    280,188.77
Discounting rate		$                      0.88	$                   0.77	$               0.67	$               0.59
Discounted cash flow		$           192,456.14	$        198,907.36	$    177,962.31	$    165,894.24	$        735,220.06
Less:
Initial Investment						$        690,000.00
PV of opportunity cost of lease						$131,660.63
Net Present Value						$        (86,440.57)
Cumulative cash flow	$ (690,000.00)	$          (470,600.00)	$      (212,100.00)	$      51,559.00	$    331,747.77
Pay beck period (years)						2.20
Cash flow	$ (690,000.00)	$           219,400.00	$        258,500.00	$    263,659.00	$    280,188.77
IRR						17%
Profitability Index						0.87

Table 2: Evaluation

(Source: created by Author)

The table above shows that NPV of the project is negative because of the inclusion of the opportunity costs. Therefore, project should not be accepted as per the NPV. The payback period of the project is 2.2 years and the cutoff period of the project is three years. Therefore, the project should be accepted. The IRR of the project is 17% as it is positive so the project should be accepted. The profitability index of the project is positive so the project should be accepted.

Statement showing break even related calculation
Particulars	Amount
Sales	$             4.00
Variable cost	$             1.40
Contribution	$             2.60
Fixed Costs	$    35,000.00
Break even units	13,462
Break even sales	$    53,846.15
Break even annual net cash inflow	$    16,153.85

Table 3: Break-even Analysis

(Source: Created by Author)

The table above shows the calculation related to break even. The breakeven units is 13462 and the break-even sales is $53846. The break even annual net cash inflow is $16153.85.

Sensitivity Analysis
Quantity Sales	Sales Unit	Cash inflow	Cash outflow	NPV	Sensitivity Percentage
Plus 20%	300000	$           882,264.07	$821,660.63	$60,603.44	170%
Minus 20%	200000	$           588,176.04	$821,660.63	($233,484.58)	-170%
Cost of capital	Cost	Cash inflow
Plus 20%	17%	$           612,683.38	$821,660.63	($208,977.25)	-142%
Minus 20%	11%	$           919,025.07	$821,660.63	$97,364.44	213%

Table 4: Sensitivity Analysis

(Source: Created by Author)

Calculation of Expected NPV
Performance	Probability	Cash inflow	Cash outflow	NPV	Probable NPV
Poor	25%	$           588,176.04	$        821,660.63	$  (233,484.58)	$    (58,371.15)
Average	50%	$           735,220.06	$        821,660.63	$    (86,440.57)	$    (43,220.29)
Excellent	25%	$           882,264.07	$        821,660.63	$      60,603.44	$      15,150.86
Expected NPV					$    (86,440.57)

Table 5: Expected NPV

(Source: Created by Author)  

Calculation of Standard deviation and Coefficient of variation
Quantity Sales	NPV	Expected NPV	Standard Deviation	Coefficient of variation
Plus 20%	$60,603.44	$            (86,440.57)	$        147,044.01	-1.70
Minus 20%	($233,484.58)	$            (86,440.57)	$      (147,044.01)	1.70
Cost of capital
Plus 20%	($208,977.25)	$            (86,440.57)	$      (122,536.68)	1.42
Minus 20%	$97,364.44	$            (86,440.57)	$        183,805.01	-2.13

Table 6: SD and coefficient of variation

(Source: Created by Author)

The risk in the financial term means uncertainty of the future outcome of the projects. The assessment of the risk highlights that the expected return from the project is -$86440.57. The standard variation measures the difference between expected and actual output. The higher the coefficient of standard variation the risker is the project. In this case, the table above shows that the co efficient of standard variations are high so the project is very risky (Scholes, 2015).

7. Replacement of Machinery

Statement showing calculation NPV from new equipment
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8
Net profit		$          370,716.10	$ 370,716.10	$ 370,716.10	$  370,716.10	$  370,716.10	$ 370,716.10	$ 370,716.10	$  370,716.10
Savings in cost		22000	22000	22000	22000	22000	22000	22000	22000
Depreciation		241500	169050	118335	82834.5	57984.15	40588.905	28412.2335	19888.56345
Revised Net Profit		$          151,216.10	$ 223,666.10	$ 274,381.10	$  309,881.60	$  334,731.95	$ 352,127.20	$ 364,303.87	$  372,827.54
Discounting factor		0.88	0.77	0.67	0.59	0.519368664	0.455586548	0.399637323	0.350559055
Discounted Cash flow	$  (850,000.00)	$          151,216.98	$ 223,666.87	$ 274,381.77	$  309,882.19	$  334,732.47	$ 352,127.65	$ 364,304.27	$  372,827.89
NPV	$ 1,533,140.09

Table 7: NPV

(Source: Created by Author)

The table above highlights that the NPV from using the new machine is positive. Therefore, the new machine should be used. The new equipment should be installed after 3^rd year because then an additional amount of $300000 should be received from old machine (Jordà et al., 2016).

Conclusion

Based on the above discussion it can be concluded that the project should be accepted. The reason is that the IRR, payback period and profitability index all indicates that the profitability of the company is high.   

Reference

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