Capital investment analysis · Famous Cake Pans, Inc.
Capital Budgeting: New Product Line
A five-year profitability and discounted-cash-flow model evaluating a $450K equipment investment to launch a new product line, tested against an 8.5% required return.
Proceed. The project clears its 8.5% required return with an IRR of 22.27%, generates $157.2K of net present value, and returns the initial outlay during Year 3.
01 · The question
Should the company fund a new product line?
Famous Cake Pans is considering a new line of pans. Launching it requires $450K of machinery at Year 0, and management expects the line to generate $750K of revenue annually for five years at a 70% cost of goods sold. The equipment depreciates straight-line over three years with no salvage value.
The decision is a capital budgeting problem: the cash goes out now and comes back over five years, so the comparison has to be made in present-value terms against the company's 8.5% required return. The model below builds the income statement, converts it to project cash flow, and discounts it.
02 · Inputs
Assumptions
Every driver is isolated as a labelled input. Nothing below is embedded inside a formula, so any assumption can be flexed and traced straight through to NPV.
| Category | Assumption | Value | Basis |
|---|---|---|---|
| Revenue | Annual revenue | $750K | Constant across the 5-year horizon |
| Margin | COGS % of revenue | 70% | Implies a 30% gross margin |
| Operating expense | Salaries & labor | $15K | Fixed annual |
| Operating expense | Rent | $10K | Fixed annual |
| Operating expense | SG&A | $5K | Fixed annual |
| Capital | Initial capex | $450K | Machinery & equipment, deployed at Year 0 |
| Capital | Useful life | 3 years | Straight-line depreciation |
| Capital | Salvage value | $0 | No residual value assumed |
| Financing | Interest expense | $3K | Fixed annual |
| Tax | Corporate tax rate | 40% | Applied to earnings before tax |
| Valuation | Discount rate | 8.5% | Required return on the project |
| Valuation | Project life | 5 years | Forecast horizon |
03 · Mechanics
Five-year profitability model
Fixed operating costs against flat revenue give a steady $195K of EBITDA. Depreciation is the only moving part in the income statement, and because the asset is written off over three years against a five-year revenue stream, reported earnings step up sharply in Year 4.
| Income statement | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|---|
| Revenue | - | 750.0 | 750.0 | 750.0 | 750.0 | 750.0 |
| Cost of goods sold | - | 525.0 | 525.0 | 525.0 | 525.0 | 525.0 |
| Gross profit | - | 225.0 | 225.0 | 225.0 | 225.0 | 225.0 |
| Salaries & labor | - | 15.0 | 15.0 | 15.0 | 15.0 | 15.0 |
| Rent | - | 10.0 | 10.0 | 10.0 | 10.0 | 10.0 |
| SG&A | - | 5.0 | 5.0 | 5.0 | 5.0 | 5.0 |
| EBITDA | - | 195.0 | 195.0 | 195.0 | 195.0 | 195.0 |
| Depreciation | - | 150.0 | 150.0 | 150.0 | - | - |
| EBIT | - | 45.0 | 45.0 | 45.0 | 195.0 | 195.0 |
| Interest expense | - | 3.0 | 3.0 | 3.0 | 3.0 | 3.0 |
| Earnings before tax | - | 42.0 | 42.0 | 42.0 | 192.0 | 192.0 |
| Income tax @ 40% | - | 16.8 | 16.8 | 16.8 | 76.8 | 76.8 |
| Net income | - | 25.2 | 25.2 | 25.2 | 115.2 | 115.2 |
Figures in $000.
Depreciation schedule
Straight-line over a three-year life: $450K ÷ 3 = $150K per year, taken in Years 1 through 3, with the asset fully written down and no salvage value thereafter.
| Depreciation | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|---|
| Beginning net book value | 0.0 | 450.0 | 300.0 | 150.0 | 0.0 | 0.0 |
| Capital expenditure | 450.0 | - | - | - | - | - |
| Depreciation | - | 150.0 | 150.0 | 150.0 | - | - |
| Accumulated depreciation | 0.0 | 150.0 | 300.0 | 450.0 | 450.0 | 450.0 |
| Ending net book value | 450.0 | 300.0 | 150.0 | 0.0 | 0.0 | 0.0 |
Figures in $000.
04 · Valuation
Cash flow, discounting, and returns
Net income is converted to cash by adding back depreciation, which is a non-cash charge, and subtracting the Year 0 capital outlay. The resulting stream is discounted at the 8.5% required return.
| Cash flow | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|---|
| Net income | - | 25.2 | 25.2 | 25.2 | 115.2 | 115.2 |
| Add back: depreciation | - | 150.0 | 150.0 | 150.0 | - | - |
| Operating cash flow | - | 175.2 | 175.2 | 175.2 | 115.2 | 115.2 |
| Capital expenditure | (450.0) | - | - | - | - | - |
| Project cash flow | (450.0) | 175.2 | 175.2 | 175.2 | 115.2 | 115.2 |
| Discounted at 8.5% | (450.0) | 161.5 | 148.8 | 137.2 | 83.1 | 76.6 |
| Cumulative cash flow | (450.0) | (274.8) | (99.6) | 75.6 | 190.8 | 306.0 |
Figures in $000. Year 0 cash flow is not discounted.
Figure 1 Project cash flow by year, shown nominal and discounted. The gap between the two bars widens with time, which is the cost of waiting for the money.
Figure 2 Cumulative project cash flow. The line crosses zero at 2.57 years, meaning the $450K outlay is recovered partway through Year 3.
05 · Conclusion
Findings and risks
- The project creates value. At an 8.5% required return the investment is worth $157.2K more than it costs, and its 22.27% IRR clears the hurdle rate by roughly 13.8 percentage points.
- Margin is the dominant driver. COGS at 70% of revenue leaves a 30% gross margin, so supplier pricing moves the answer far more than any operating expense line. A sustained increase in unit cost is the single largest threat to the return.
- Reported earnings understate early economics. The three-year write-off depresses Year 1 to 3 net income while cash flow stays healthy. Judging the project on accounting profit alone would understate it.
- Flat revenue is an assumption, not a forecast. The model holds revenue constant at $750K for five years. Demand should be validated before the capital is committed, since the entire return depends on volume holding.
- Recommended next step. Build a sensitivity grid across COGS percentage and discount rate, and a downside case, before the investment goes to committee.
The full model: assumptions, income statement, depreciation schedule and DCF, with formulas intact.