Question

Javier Arino is a senior manager with the North American group of Cortez Products. He has just received the financial information he requested about a new product proposal from one of his division managers. The product, which goes under the code name Caliente-X, has undergone market research nests and the division manager is excited about its potential, Javier asked for and received the following information:

The company believes that the product's life cycle is only four years. That is, the firm will consider only cash flows in the next four years.

The project requires an initial cash investment outlay of $10 million, which will be depreciated on a straight line basis over the next years.

The project will require an initial net working capital outlay of $200,000 which can be recovered at the end of the project.

The firm's marginal tax rate it 40 percent; the cost of capital is 16 percent.

Cash revenues and cash operating expenses for the next four years are expected to be (in millions of dollars):

Year 1 $11.50 Year 2 $16.50 Year 3 $20.30 Year 4 $10.20 Cash Revenues Cash Operating Expenses 8.5 12 14.3 6.7

Questions:

1. Suppose the opportunity cost of capital for new product introductions at Cortez Products is 16 percent. What is the NPV of Caliente-X?

2. What is the IRR on the Caliente-X investment proposal?

3. What is the MIRR?

4. What is the payback period for Caliente-X?

5. Should Javier accept the project?

6. Suppose Cortex Products has 1 million shares of outstanding common stock. If Javier decides to go ahead with Caliente-X, what should happen to the per share market price of Cortes Products when the project is announced to the public?

Answer 1

Answer 1.

NPV of Project

				(in $ millions)
	Year 0	Year 1	Year 2	Year 3	Year 4
Revenue		11.5	16.5	20.3	10.2
Less: Operating expense		8.5	12	14.3	6.7
Less: Depreciation		2.5	2.5	2.5	2.5
Profit		0.5	2	3.5	1
Less: Tax		0.2	0.8	1.4	0.4
Profit after tax		0.3	1.2	2.1	0.6
Cash Flows(PAT+ Depreciation)		2.8	3.7	4.6	3.1
Initial Outlay	-10.2
Terminal Cash Flow					0.2
Discount Factor@16%		0.862	0.743	0.641	0.552
Net Present value of Cash flows	-10.2	2.4136	2.7491	2.9486	1.8216
Net Present Value	-0.2671

Answer 2

IRR of Project

IRR
Period	Cashflow	PV Factor @ 10%	PV@10%	PV @16%
0	-10.2		-10.2	-10.2
1	2.8	0.909	2.5452	2.4136
2	3.7	0.826	3.0562	2.7491
3	4.6	0.751	3.4546	2.9486
4	3.3	0.683	2.2539	1.8216
Total			1.1099	-0.2671
	10%+1.1099*(16%-10%/1.1099-(-0.2671)
IRR	10%+4.84%=14.84%

Answer 3. Under MIRR positive cash flows are assumed to be invested at cost of capital and negative cash flows are assumed to financed at its financing cost. where as in IRR cash flows are assumed to be invested at IRR iteself.

Answer 4

Payback Period=2+3.5/4..6

=2.76 years

Answer 5.

Project should not be accepted as NPV is negative and IRR is below cost of capital.

Answer 6

The per share value must decrease as follows=-0.2671/1

=0.2671$