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Sampaguita Avenue, Mapayapa Village, Diliman, Quezon City 1101, Philippines

Tel: (632) 468 8944/ Telefax: (632) 932 0104 /

Capital Budgeting and Cash Flow Estimation

Allied Food Products
Brigham | Houston

Lola, Aira V.
Loy-a, Ivy S.
3rd Trimester, AY 2015 – 2016

Lilian Bunuan

Table of Contents
I. Perspective............................................................................................................................ 1
II. Facts of the Case ................................................................................................................... 1
III. Identify the Problem ............................................................................................................. 1
IV. Principles ............................................................................................................................... 1
V. Computations and Analysis................................................................................................... 3
VI. Recommendations ................................................................................................................ 11
VII. References ............................................................................................................................ 11

I. Perspectives
Allied Food Products is a firm that processes and distributes wide variety of food products. It
was formed in 1981 and was also known to be one of the best firms in the food industry. And now, it is
considering an expansion on its business by adding fruit juice products in their food line. The expansion
plan is to produce a new fresh lemon juice product.
As the recently hired assistant of the director of capital budgeting, the task is to evaluate the
new project.
II. Facts of the Case
The production of the lemon juice will take place in an unused building which is next to Allied’s
Fort Myers plant. The building is owned by the Allied and is fully depreciated. The equipment to be used
for the production amounts to $200,000 with shipping and installation that cost $40,000. Also, there is
an increase by $25,000 in the inventories and by $5,000 for the accounts payable. All these costs will be
incurred at year 0 (t=0). Through a special ruling, there could be a depreciation of machinery as 3 year
property under the MACRS system. The depreciation rates that can be applied are 33%, 45%, 15%, and
The project is expected to run for 4 years which is to be terminated then. One year after the
project was done, the cash inflows are assumed to begin (t=1) until the 4th year (t=4). The amount of the
salvage value is $25,000 and is expected at the end of the project’s life (t=4).
There is an expected total of 100,000 units of unit sales per year with an expected sales price of
$2.00 for each unit. A total of 60% of dollar sales is expected for the cash operating costs of the project
(total operating costs less depreciation). The tax rate of Allied is 40% and a WACC of 10%. And
consequently, the lemon juice project is assumed to have a risk equal to the other assets.
III. Identify the Problem/ Objectives
The equipment that Allied is going to use in its project is fully depreciated. For that, a problem
arises where the full depreciation of the building may decrease the total assets, net income, and the
stockholders’ equity.
The NPV is negative which left a choice of rejection against the project. Also, the IRR and MIRR
produces a result that suggests to reject the project.
IV. Principles/ Decision-Making Tools
In capital budgeting, capital are the long term assets that are used in a production, while a
budget is a plan outlining the projected expenditures at the future time. Therefore, the capital budget is
a whole process of the project analyzation and deciding what to include in the capital budget (Brigham,

2013, p. 368).
The Congress changes the methods for permissible tax depreciation from time to time for tax
purposes. Earlier to 1954, the required method is the straight line method. In 1954, the accelerated
methods were permitted which is then replaced by Accelerated Cost Recovery System (ACRS) on 1981.
In 1986, as a part of the Tax Reform Act, the ACRS was changed to Modified Accelerated Cost Recovery
System (MACRS) (Brigham, 2013, p. 481).
In the calculation of the Weighted Average Cost of Capital (WACC), the primary concern is the
capital coming from the investors. Items including debt, preferred stock, and common equity are
supplied by the investors and known as the capital components. The accounts payable and accruals are
not part of the investor-supplied capital because they do not originate from the investors (Brigham,
2013, p. 338-339).
The Net Present Value (NPV) is the present value of the free cash flows of a project discounted
at the cost of capital. It shows the extent of contribution of a project to the shareholder wealth. The
larger the NPV, the more value it can add. And the value in addition means a higher stock price.
Therefore, the NPV is considered as the best in selection criterion. Before the use of NPV, the project
must be identified first whether it is an independent or mutually exclusive project. Projects with cash
flows that are not affected to each other are independent projects. In mutually exclusive projects, only
one project can be accepted (Brigham, 2013, p. 371-373).
The present value of the inflows of a project is force by a discount rate called Internal Rate of
Return (IRR) to equal the project’s cost. This is the same in forcing the NPV to equal to zero. Also, the
IRR is an estimation of the project’s rate of return and is comparable to the Yield to Maturity of a bond
(Brigham, 2013, p. 373).
The Internal Rate of Return (IRR) is according on an assumption that the cash flows of a project
can be reinvested at the IRR. Generally, this assumption is incorrect which causes the IRR the true return
of a project. For this reason, a new measure called Modified Internal Rate of Return (MIRR) is used
(Brigham, 2013, p. 381).
Historically, before the use of the NPV method, the payback period is used as the selection
criterion. It is defined as the number of years needed to recover the invested funds in a project coming
from its cash flows (Brigham, 2013, p. 387).
There are two types of project, expansion project and replacement project. When a firm makes
an investment, it is an expansion project. But when the firm replaces its existing assets, it is a
replacement project (Brigham, 2013, p. 402).

Sensitivity Analysis measures the percentage of change in the NPV resulting from a given
percentage change in an input, the other variables are held at their expected values (Brigham, 2013, p.
In a replacement chain (common life) approach, there is an involvement of finding the NPV of a
project over a number of years, which is also the life of another project. The extended NPV of the
project will then be compared to the NPV of another project (Brigham, 2013, p. 419).
The Equivalent Annual Annuity (EAA) Method calculates the annual payments that will be
provided by a project if it is an annuity. In the comparison of projects with unequal lives, the one with
the higher equivalent annual annuity (EAA) should be chosen (Brigham, 2013, p. 420).
The measure of the extent of the actual return that is likely to deviate from the expected return
is called standard deviation. When it is divided by the expected return, it will give an answer of another
measurement of risk which is the coefficient of variation. The coefficient of variation is the risk of return
per unit and provides a measure of a more meaningful risk when the expected returns on the two
alternatives are different (Brigham, 2013, p. 264-265).
V. Computations and Analysis
a. Allied has a standard form that is used in the capital budgeting process. (See Table IC 12.1.) Part
of the table has been completed, but you must replace the blanks with the missing numbers.
Complete the table using the following steps:
1. Fill in the blanks under Year 0 for the initial investment outlays: CAPEX and ΔNOWC.
2. Complete the table for unit sales, sales price, total revenues, and operating costs excluding
3. Complete the depreciation data.
4. Complete the table down to after –tax operating income and then down to the project’s
operating cash flows, EBIT(1 – T) + DEP.
5. Fill in the blank under Year 4 for the terminal cash flows and complete the project free cash
flows line. Discuss the recovery of net operating working capital. What would have
happened if the machinery were sold for less than its book value?
Allied’s Lemon Juice Project (in Thousands) Table IC 12.3
End of year 0 1 2 3 4
I. Investment Outlays
Equipment cost -200
Installation -40
CAPEX -240
Increase in inventory -25

Increase in accounts payable 5

II. Projects Operating Cash Flow
Unit sales (thousands) 100 100 100 100
Price/unit $2.00 $2.00 $2.00 $2.00
Total revenues $200 $200 $200 $200.0
Operating costs excluding depreciation 120 $120.0 120 120
Depreciation 79.2 108 36 16.8
Total costs $199.2 $228.0 $156 $136.8
EBIT (or operating income) 0.8 -28 $44.0 63.25
Taxes on operating income 0.3 -11.2 17.6 25.3
EBIT (1 – T) = After-tax operating income $0.48 ($16.8) $26.4 $37.95
Add back depreciation 79.2 108 36 16.8
EBIT(1 – T) + DEP $ -260 $ 79.7 $91.2 $62.4 $54.7
III. Project Termination Cash Flows
Salvage value (taxed as ordinary income) 25
Tax on salvage value 10
After-tax salvage value 15
ΔNOWC = Recovery of net operating working 20
Project free cash flows = EBIT(1 – T) + DEP – -260 79.7 91.2 62.4 89.7

The amount of the net operating working capital is earned back at the end of the year. Since there is
no book value, the whole salvage value is taxable as a whole. If the asset was sold for an amount that is
less than the book value, there will be a positive tax effect.
b. 1. Allied uses debt in its capital structure, so some of the money used to finance the project will
be debt. Given this fact, should the projected cash flows be revised to show projected interest
charges? Explain.
A revision of the projected cash flows is not needed to show interest charges. The reason is that
the effects of debt financing are already part the capital expenditure which is used in discounting the
cash flows.
2. Suppose you learned that Allied had spent $50,000 to renovate the building last year,
expensing these cost. Should this cost be reflected in the analysis? Explain.
The renovation expense is a sunk cost so it would not affect the decision. Therefore, it is not
needed to be a part of the analysis.
3. Suppose you learned that Allied could lease its building to another party and earn $25,000 per
year. Should that fact be reflected in the analysis? If so, how?

The scenario given of the lease payment is an opportunity cost. It gives way to the question
whether the Allied should use the building for the production of the lemon juice or should be rented from
an amount of $25,000 per year. If the given fact will be reflected in the analysis, it will be shown as a
deduction from the cash flows that the company would have.
4. Assume that the lemon juice project would take profitable sales away from Allied’s fresh
orange juice business. Should that fact be reflected in your analysis? If so, how?
The fruit juice business of the Allied Food Products will be affected by the new project of the firm,
the lemon juice. The sales of the first fruit juices of Allied will decreased because a part of it will be pulled
by the sales of the lemon juice. This is an externality of Allied. Since a part of the sales of the lemon juice
is taken from first fruit juices, the amount of revenue in the analysis is overstated. Therefore, the amount
of revenue decreased from the first fruit juices should be deducted to the revenue in the analysis.
c. Disregard all the assumptions made in Part b and assume there is no alternative use for the
building over the next 4 years. Now calculate the project’s NPV, IRR, MIRR and payback. Do
these indicators suggest that the project should be accepted? Explain.
The amount of NPV is negative so it must be rejected. The IRR and MIRR are both less than the
cost of capital so they are both to be rejected. Considering the results, the project should not be taken.
d. If this project had been a replacement rather than an expansion project, how would the analysis
have changed? Thin about the changes that would have occur in the cash flow table.
If a replacement is used rather than an expansion project, there would be two cash flows: one, if
the project is taken and two, if not. Therefore, there will be a need for a column for project not taken, a
column for project taken, and a column for the difference of the two. The column for the difference is the
one that will be used for computing the NPV,IRR, MIRR, Payback and other computations.
e. 1. What three levels, or types, of project risk are normally considered?
There are three specific types of risks involved in the analysis of capital budgeting.
The first one is the Stand-Alone Risk. This is a project’s risk if it is the only asset the firm has and
if the firm is the only stock in the portfolio of each investors. It is measured by the variability of the
expected return of the project. The diversification is totally ignored.
Next one is the Corporate or Within-Firm Risk. It is the risk in the project contrary to its investors.
The risks considers the project as the only asset in the portfolio assets of the firm. Therefore, parts of its
risks will be decreased by the diversification within the firm. This risks is measured by the impact of
project on the uncertainty regarding the future returns of the firm.

Lastly, the Market or Beta Risk. This is the riskiness of the project that is seen by a well-
diversified stockholder who recognizes that the project is the only one in the firm’s asset and that the
stock of the firm a part of his or her stock portfolio. The risk is measured by its effect on the beta
coefficient of the firm.
2. Which type is most relevant?
All firms’ management has its main goal which is to maximize the shareholders’ wealth. For that,
the Market Risk is the most relevant risk. But then, all are affected by the total risk of a firm. Therefore,
the Within-Firm Risk should also be taken into consideration.
3. Which type is easiest to measure?
The easiest to measure is the Stand-Alone Risk since it is measured by the variability of the
expected return. Compared to the measurements of the other two risks, it is way more quantifiable.
4. Are the three types of risk generally highly correlated?
Considering that usually the projects that businesses take are in its main business, the Stand-
Alone risk is more likely to be highly correlated with the corporate risk which is to be highly correlated to
the market risk.
f. 1. What is sensitivity analysis?
Sensitivity Analysis measures the percentage of change in the NPV resulting from a given
percentage change in an input, the other variables are held at their expected values.
2. How would you perform a sensitivity analysis on the unit sales, salvage value, and WACC for
the project? Assume that each of these variables deviates from its base-case, or expected, value
by plus or minus 10%, 20%, and 30%. Explain how you would calculate the NPV, IRR, MIRR and
payback for each case; but don’t do the analysis unless your instructor asks you to.
The given value for the unit sales was 100. It is then the base-case. If you consider the
assumption of plus and minus by 10%, 20%, and 30%, the unit sales that will be used in the sensitivity
analysis are 110 (100(1+0.1)), 90 (100(1-0.1)), 120 (100(1+0.2)), 80 (100(1-0.2)), 130 (100(1+-0.3)), and
70 (100(1-0.3)). Using the recent computed values, the table for the analysis will be recomputed with
them used as the new amount for units. Then, a different cash flows will be computed. And for that
reason, the amount of NPV, IRR, MIRR and payback were all going to be different. The computation for
the salvage value and cost of capital will also be recomputed.
3. What is the primary weakness of sensitivity analysis? What are its primary advantages?
The sensitivity analysis doesn’t show the effects of diversification and it does not show any
possible measures for forecast errors. But then, it tells how sensitive a NPV to the sales forecast which

mean the riskiness of the project. In terms of the sensitivity of the sales, it concerns the revenue
that are fixed to a long term contract.
g. Unrelated to the lemon juice project, Allied is upgrading its plant and must choose between two
machines that are mutually exclusive. The plant is highly successful, so whichever machine is
chosen will be repurchased after its useful life is over. Both machines cost $50,000; however,
Machine A provides after-tax savings of $17,500 per year for 4 years, while Machine B provides
after-tax savings of $34,000 in Year 1 and $27,500 in Year 2.
1. Using the replacement chain method, what is the NPV of the better machine?

Both of the projects gave a positive NPV. But since the Machine B has the higher NPV, it is the
one that will be chosen.
2. Using the EAA method, what is the EAA of the better machine?

Same as the NPV, the Machine B is the accepted and chosen project because this will provide a
higher payment flow that is better for the Company.
h. Assume that inflation is expected to average 5% over the next 4 years and that this expectation
is reflected in the WACC. Moreover, inflation is expected to increase revenues and variable costs

by this same 5%. Does it appear that inflation has been dealt with property in the initial analysis
to this point? If not, what should be done and how would the required adjustment affect the
For the first set of data give, there is no inflation. Therefore, the sales price is constant. So in case
of a inflation, the revenue and costs will be both increased by 5%per year. Considering that the revenues
are larger compared to the operating costs, the inflation will cause the cash flows to increase which will
lead to increase of NPV, IRR, and MIRR and, shorter Payback.
i. The expected cash flows, considering inflation (in thousands of dollars), are given in Table IC
12.2. Allied’s WACC is 10%. Assume that you are confident about the estimates of all the
variables that affect the cash flows except unit sales. If product acceptance is poor, sales would
be only 75,000 units a year, while a strong consumer response would produce sales of 125,000
units. In either case, cash costs would still amount to 60% of revenues. You believe that there is
a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of
average acceptance (the base case). Provide numbers only if you are using a computer model.
1. What is the worst-case NPV? The best-case NPV?
Worst-Case NPV
Projects Operating Cash Flow:

Unit sales (thousands) 75 75 75 75

Sales price (dollars) $ 2.100 $ 2.205 $ 2.315 $ 2.431
Total revenues $ 157.5 $ $ $
165.375 173.625 182.325
Cash operating costs (60%) 94.5 99.225 104.175 109.395
Depreciation 79.2 108 36 16.8
EBIT (or operating income) $ (16.2) (S $ 33.45 $ 56.13
Taxes on operating income (40%) -6.48 -16.74 13.38 22.452
EBIT (1 – T) = After-tax operating income $ (9.72) ($ $ 20.07 $ 33.678
Plus depreciation 79.2 108 36 16.8
EBIT(1 – T) + DEP $ 69.48 $ 82.89 $ 56.07 $ 50.48

Terminal Cash Flows:

Salvage value 25
Tax on SV (40%) 10
After-tax salvage value 15
Project free cash flows -260 69.48 82.89 56.07 85.48

WACC= 10%
NPV= (27.8)
Best-Case NPV
Projects Operating Cash Flow:

Unit sales (thousands) 125 125 125 125

Sales price (dollars) $ 2.100 $ 2.205 $ 2.315 $ 2.431
Total revenues $ 262.5 $ $ $
275.625 289.375 303.875
Cash operating costs (60%) 157.5 165.375 173.625 182.325
Depreciation 79.2 108 36 16.8
EBIT (or operating income) $ 25.8 $ 2.25 $ 79.75 $ 104.75
Taxes on operating income (40%) 10.38 0.9 31.9 41.9
EBIT (1 – T) = After-tax operating income $ 15.42 $ 1.35 $ 47.85 $ 62.85
Plus depreciation 79.2 108 36 16.8
EBIT(1 – T) + DEP $ 94.62 $ 109.35 $ 83.85 $ 79.65
Terminal Cash Flows:
Salvage value 25
Tax on SV (40%) 10
After-tax salvage value 15
Project free cash flows -260 94.62 109.35 83.85 114.65

WACC 10%
NPV 57.7

2. Use the worst-case, most likely case (or base-case), and best-case NPVs with their
probabilities of occurrence, to find the project’s expected NPV, standard deviation, and
coefficient of variation.


25% -27.8 15 -42.8 1831.8 457.96

50% 15 15 0 0.0 0.0
25% 57.8 15 42.8 1831.8 457.96
SD= 30.3

j. Assume that Allied’s average project has a coefficient of variation (CV) in the range of 1.25 to
1.75. Would the lemon juice project be classified as high risk, average risk, or low risk? What
type of risk is being measured here?
The actual CV of the project is 2.0. It is higher compared to the range of 1.25 to 1.75, which
makes the actual CV to be in the high-risk category. The CV measures the Stand-Alone Risk.
k. Based on common sense, how highly correlated do you think the project would be with the
firm’s other assets? (Give a correlation coefficient or range of coefficients, based on your
It is only reasonable to think that the economy is strong and the people are buying a lot of lemon
juice meaning that the sales are high, which then would give good correlation between the project and
the other businesses of the firm. But then, the different businesses in the firm can be more or less
successful. Based on our judgment, the correlation could be less than +5.0.
l. How would the correlation coefficient and the previously calculated ơ combine to affect the
project’s contribution to corporate, or within-firm, risk? Explain.
If the cash flow of the project is highly correlated to the aggregate cash flows, the project has
high corporate risk. But if the cash flows are uncorrelated to the aggregate cash flows, the acceptance of
the project will decrease the total risk of the firm, then it would be less than suggested by the Stand-
Alone Risk. Same case when the cash flows are positively correlated but not perfect. If there is a negative
correlation at all, accepting the project will lessen the risk of the firm.

m. Based on your judgement, what do you think the project’s correlation coefficient would be with
respect to the general economy and thus with returns on “the market”? How would correlation
with the economy affect the project’s market risk?
The project is more likely to have a positive correlation to other assets in the economy. Since
Allied produces food, it is less risky compared to the other firms. But then, some people also buys non-
food related products when the economy is good. The range of correlation could be +0.8, ranges from
+0.4 to +0.9.
There is no direct effect between the correlation and the project’s market risk.
n. Allied typically adds or subtract 3% to its WACC to adjust for risk. After adjusting for risk, should
the lemon juice project be accepted? Should any subjective risk factors be considered befre the
final decision is made? Explain.
In consideration to the above-average risk of the project, the cost of capital would be 13 percent.
With this discount rate, that amount of NPV will be $2,226, therefore it will not be accepted. For a low
risk project, there will be 7 percent for the percent for the cost of capital, then NPV would be $34,117,
meaning it is going to be a profitable project on a risk-adjusted basis. For the possible subjective risk
factors, one thing to consider is potential lawsuits which will make the project riskier. Also, if the assets
can be easily sold, the project can be less risky.
VI. Recommendations/ Course of Action
In order to reduce the amount that the depreciation may cause to the assets, net income, and
shareholders’ equity, the company may choose to use a building with less depreciation or at least not
fully depreciated.
For the firm to increase its NPV, one of the things it may do is to reduce the cost. Another way is
to just simply choose a project that will produce higher revenue. Lastly, a project with a shorter number
of years will give a higher NPV for the reason that there will be less number of cash flows to add to the
initial investment.
VII. References
Brigham, E. F., & Ehrhardt, M. C. (2014). Financial Management: Theory & Practice (14th ed.). Cengage
Learning Asia Pte.
Brigham, E. F., & Houston, J. F., Dr. (2014). Fundamentals of Financial Management (13th ed.). Pasig,
Philippines: Cengage Learning Asia Pte.