ASSIGNMENT 4 - Management Accounting Case: Cayuga Cookies, Inc

Assignment 4: Management Accounting Case: Cayuga Cookies, Inc.
Due Week 10, Day 7 (225 points)

The specific course learning outcomes associated with this assignment are:

• Determine how capital budgeting is used in long-term financial decisions.
• Apply management accounting concepts to identify and process relevant financial
information for decision-making purposes.
• Use technology and information resources to research issues in financial reporting and
analysis.
• Write clearly and concisely about financial reporting and analysis using proper writing
mechanics.

Assignment:

Sophie Morgan, President of Cayuga Cookies, Inc. (CCI), was trying to decide whether to expand
the company by adding a new product line. The proposal seemed likely to be profitable and
adequate funds to finance it could be obtained from outside investors.

CCI had long been regarded as a well-managed company. It had succeeded in keeping its
present product lines up to date and had maintained a small but profitable position in a highly
competitive industry.

The amount of capital presently employed by the company was approximately $4,000,000, and
was expected to remain at this level whether the proposal for the new product line was accepted
or rejected. Net income from existing operations amounted to about $400,000 a year, and
Morgan’s best forecast was that this would continue to be the income from present operations.

Introduction of the new product line would require an immediate investment of $400,000 in
equipment and $250,000 in additional working capital. A further $100,000 in working capital
would be required a year later.

Sales of the new product line would be relatively low during the first year, but would increase
steadily until the sixth year. After that, changing tastes and increased competition would probably
begin to reduce annual sales. After eight years, the product line would probably be withdrawn
from the market. At that time, the company would dispose of the equipment and liquidate the
working capital. The cash value of steps to close the product line at that time would be about
$350,000.

The low initial sales volume, combined with heavy promotional outlays, would lead to heavy
losses in the first two years, and no net income would be reported until the fourth year. The profit
forecasts for the new product line are summarized in Exhibit 1.

Morgan was concerned about the effect this project would have on CCI's overall reported
profitability over the next three years. On the other hand, "eyeballing" the figures in Exhibit 1 led
Morgan to guess that if the proposal were analyzed using after-tax cash flows discounted at 10
percent, it might well show a positive net present value, and hence could be a worthwhile
investment opportunity.


Exhibit 1
Income Forecast for New Product Line

Year Forecasted
Incremental
Cash Flow
from
Operations1

(1)

Depreciation
Expense on
New
Equipment2

(2)

Forecasted
Incremental
Income
Before Tax
(3) = (1 + 2)



Income Tax3

at 40%
(4)

Forecasted
Incremental
Net Income
After Tax4

(5) = (3 + 4)
1 (350,000) (50,000) (400,000) 160,000 (240,000)
2 (100,000) (50,000) (150,000) 60,000 (90,000)
3 0 (50,000) (50,000) 20,000 (30,000)
4 200,000 (50,000) 150,000 (60,000) 90,000
5 500,000 (50,000) 450,000 (180,000) 270,000
6 1,000,000 (50,000) 950,000 (380,000) 570,000
7 900,000 (50,000) 850,000 (340,000) 510,000
8 650,000 (50,000) 650,000 (240,000) 360,000

Notes:

1. In this column, numbers in parentheses indicate cash outflow.
2. In this column, numbers in parentheses indicate an expense (i.e., something that reduces
profits). For the purpose of this analysis, we may use these depreciation figures for the
determination of both Net Income and Income Tax that will be paid to the government.
3. When forecasted incremental income before taxes is negative, the firm is entitled to a tax
rebate at 40%, either from taxes paid in previous years or from taxes currently due on
other company operations. Therefore, in this column, numbers in parentheses indicate
taxes paid to the government and numbers not in parentheses indicates tax rebates
received from the government.
4. In this column, numbers in parentheses indicate a net loss produced by the new product
line and numbers not in parentheses indicate a net profit made by this new product line.


Required:

1. Calculate the nominal and discounted payback periods for this proposed project.

2. Calculate the net present value and internal rate of return of the proposed project.

3. Referring to your analysis in parts (1) and (2), what is your recommendation regarding
the proposed project under the following three scenarios (note: comment on any
similarities or differences in your recommendations across these three scenarios):

a. If CCI was a private company, owned entirety by Sophie Morgan?
b. If CCI was a publicly owned company, with shares owned by a large number of
small investors, and Morgan purely a salaried administrator?
c. If CCI was a wholly owned subsidiary of a much larger company and Morgan
expected to be a candidate to succeed one of the parent company's top
executives who will retire from the company in about two years from now?