Heavenly Foods

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Heavenly Foods Corporation (see Notes)

Question 1:

Since the project will be financed in part by debt, should the cash flow statement include interest expenses? Explain. Should the $262,500 test marketing cost be included in the analysis? Explain.

The cash flow statement should not include interest expense or dividends. The return required by the investors furnishing the capital is accounted for in the 12 percent cost of capital (WACC) used to discount the cash flows, therefore including interest expense and also discounting would be "double counting." Put another way, if we both subtracted interest (and dividends) and also discounted at the cost of capital, we would in effect be deducting capital costs twice.

The $262,500 test marketing cost is a sunk cost, not an incremental cash flow, so it should not be included in the analysis. Accepting or rejecting the project will have no impact on that cash flow.

Question 2:

Suppose All Natural Foods, Inc. actually made a firm offer to lease the High Energy--Lite production site for $43,750 a year (beginning-of-year payments)for 20 years. How should that information be incorporated into the analysis? If Heavenly Foods does not have an opportunity to lease the space, does this mean that the space is "free," or costless, from the standpoint of the lite product project?

If the plant space could be leased to another party, then, by accepting this project, Heavenly Foods would be forgoing the opportunity to receive $43,750 in annual lease payments. This opportunity cost should be assigned to the project and thus be included in the analysis. Note that the opportunity cost cash flow must be net of taxes, so it would be treated as a $43,750(1 - T) = $43,750(0.6) = $26,250 annual outflow.

The space would be free if and only if it could not be sold, rented, or used for any other purpose. It is stated in the case that space will be needed for the firm's other projects within the next 2 to 3 years....
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