Caspian Sea Drinks is considering the production of a diet drink. The expansion of the plant and the purchase of the equipment necessary to produce the diet drink will cost $27.00 million. The plant and equipment will be depreciated over 10 years to a book value of $1.00 million, and sold for that amount in year 10. Net working capital will increase by $1.07 million at the beginning of the project and will be recovered at the end. The new diet drink will produce revenues of $9.36 million per year and cost $2.23 million per year over the 10-year life of the project. Marketing estimates 11.00% of the buyers of the diet drink will be people who will switch from the regular drink. The marginal tax rate is 25.00%. The WACC is 14.00%. Find the IRR (internal rate of return).
calculation of depreciation
Depreciation = [Cost - Book value at the end] / useful life = (27 - 1) / 10 = $2.6 million
total outflow = purchase value of equipment + Net Working Capital
= 27 + 1.07 = $28.07 million
calculating operating cash flows:
Revenue from diet drink = 9,360,000
less : costs = 2,230,000
less: Depreciation = 2,600,000
profit before tax = 4,530,000
less : tax @ 25% = 1,132,500
profit after tax = 3,397,500
Add : Depreciation = 2,600,000
Operating Cash Flow = 5,997,500
Operating cash flow will be same every year except for last year because in last year there will be recovery of working capital
so cash flow from years 1 to 9 = $5,997,500
in year 10 it is = 5,997,500 + 1070000 = $7,067,500
IRR is the rate where NPV of the project is 0
| year | Net cash flow |
| 0 | -28,070,000 |
| 1 | 5997500 |
| 2 | 5997500 |
| 3 | 5997500 |
| 4 | 5997500 |
| 5 | 5997500 |
| 6 | 5997500 |
| 7 | 5997500 |
| 8 | 5997500 |
| 9 | 5997500 |
| 10 | 7067500 |
| IRR | 17.09% |
Using Excel ( formula is =IRR(select all above cells) i.e., from year 0 to 10) ) IRR comes to 17.09%
NOTE: The percentage of buyers shifting from regular to diet drink is irrelevant for this project.
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