Tasty Foods Case Frozen Pastries Decision Case Study
The paper determines the NPV, IRR and the payback period for the plan to introduce Frozen Pastries line. It also analyzes the impact of a competitor entering the market and uses sensitivity analysis to assess the effects of changes in a number of variables on the NPV of the project. Based on the analysis, the paper gives a recommendation for the management of the company.
NPV, IRR and Payback Period
In the determination of cash flows for the project, the cost paid to the marketing consulting firm is excluded from the analysis. It is a sunk cost hence it is irrelevant in evaluating this investment. Overhead costs of the division are allocated to the line for purposes of determining profit before tax and profit after tax. It is added back in estimating expected cash flows since the addition of Frozen Pastries line does not affect the amount of overheads of the division. The same amount will be incurred irrespective of the decision of the management.
The net present value of the project is $50,186 implying that its present value of benefits outweighs the present value of costs. Since the value is positive, the project is viable hence the management should accept the idea and establish the Frozen Pastries Line. The internal rate of return for the project is 17.22%. It implies that the discount rate must be at least 17.23% for the project’s net present value to be negative. Since the project’s IRR is more than the firm’s Weighted Average Cost of Capital (WACC), the project is viable hence the management should invest in it. The payback period is 4.959 years indicating that it will take the firm four years 11.5 months to recover the initial cost of purchasing the special freezer ($160,000). The special freezer is expected to last for eight years. The payback period is less than the useful life of the project. The management should accept the project since the company will recoup the initial investment before the end of the freezer’s useful life.
If a competitor enters the market during year one, the viability of the is adversely affected. The project's net present value will decline to -$43,672 indicating that the investment will no longer be viable. Since the probability of the competitor entering the market is 30%, the expected net present value of the project will be -$13,102. In this case, the company will make losses if it invests new product line. The payback period for the project will increase to 7.917 years. The company will only recover its initial investment in the last few months of the freezer’s useful life. The internal rate of return for t also declines to 0.5%, far much below the required rate of 10%.
Sensitivity analysis/ results of Monte Carlo simulation
If the revenue for the first year is $70,000 and other variables are at minimum values as provided, the net present value of the project will be $14,605. Under the expected values, the net present value of the product is $50,186. An increase in revenue and other costs at maximum values, the project will not be viable since its net present value is -$25,532. This indicates that the project’s NPV is highly sensitive to changes in WACC, expected tax rate, percentage of operating costs to total revenue, among other factors.
Conclusion and Recommendation
The project is viable as its NPV is positive, IRR is more than the firm’s WACC and its payback period is less than the freezer’s useful life. Therefore, the company should introduce the product line in the division. The entry of a competitor in the first year will negatively affect the profitability of the investment. The sensitivity analysis indicates that the NPV of the investment is highly reactive to changes in revenue, costs, WACC, tax rate, among other factors.
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