three Question
Henry Doyle the president of King’s sugar is evaluating the addition of a new sugar-processing mill, to make white sugar, and eliminate the need to buy white sugar from its competitor, Kennard’s sugar company. King’s sugar makes brown sugar only, but would need a mill to process the brown sugar into white sugar. Kennard’s company produces white sugar from the raw sugar cane. Doyle believes that the new mill will bring in additional revenues and reduce operating costs. The competitor had excess capacity of white sugar that it sells to other sugar mills. Therefore, building the new mill would compete with Kennard’s mill. The new mill will cost $20 million in addition to the working capital requirements. Henry Doyle is wondering whether the investment can be justified. The project is expected to be 6 years until 2025.
The construction of the mill will take two years. $18 million will be spent in 2019, and $2 million in 2020. It is expected that when the plant start operating fully in 2020, the company’s operating costs will be reduced because the savings will be derived from the cost differences of producing versus buying white sugar from Kennard’s mill. The cost savings will be $ 2.8 million in 2020 and $ 3.7 million for the next five years. The company uses 15 % as the cost of capital. The following are the financial projections for the new mill.
|
2019 |
2020 |
2021 |
2022 |
2023 |
2024 |
2025 |
Capital Investment 18000。 2000 0 0 0 0 0
Net working capital (10% of
incremental sales)
Sales revenue 6000 10600。 10600 10600 10600 10600
Cost of goods sold (75% sales)
SG&A (5% sales)
Operating savings 2800。 3700。 3700。 3700。 3700。3700
Depreciation。 2800。 3400 3400。 3400。 3400。 3400。3400
Taxes 40%
Answer all of the questions.
1. What is the net present value (NPV) and internal rate of return (IRR) for the investment?
2. What is the payback period of the project?
3. Would you recommend that King’s sugar go ahead with making this investment? Why?