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 $25.00 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 $1.19 million at the beginning of the project and will be recovered at the end. The new diet drink will produce revenues of $8.78 million per year and cost $2.04 million per year over the 10-year life of the project. Marketing estimates 10.00% of the buyers of the diet drink will be people who will switch from the regular drink. The marginal tax rate is 29.00%. The WACC is 10.00%. Find the IRR (internal rate of return).
Annual depreciation = (cost - salvage value)/10 years = (25-1)/10 = $2.4 million per year
Income statement:
YEARS | ||||||||||
1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | |
Revenues | 8.78 | 8.78 | 8.78 | 8.78 | 8.78 | 8.78 | 8.78 | 8.78 | 8.78 | 8.78 |
less: expenses | ||||||||||
Annual costs | 2.04 | 2.04 | 2.04 | 2.04 | 2.04 | 2.04 | 2.04 | 2.04 | 2.04 | 2.04 |
Depreciation | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 |
EBIT | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 |
less: Tax @ 29% of EBIT | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 |
Net income | 3.08 | 3.08 | 3.08 | 3.08 | 3.08 | 3.08 | 3.08 | 3.08 | 3.08 | 3.08 |
Next we compute operating cash flow:
YEARS | ||||||||||
1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | |
EBIT | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 | 4.34 |
Add: Depreciation | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 |
less: Taxes | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 | 1.26 |
Operating cash flow | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 |
As 10% of the buyers of diet drink are those who switch from the regular drink the opportunity cost here will be = 10% of $8.78 million = $0.878 million
Thus the projected cash flows will be:
YEARS | |||||||||||
0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | |
Operating cash flow | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | 5.48 | |
Changes in Net working capital | -1.19 | 1.19 | |||||||||
Capital spending | -25.00 | 1.00 | |||||||||
Opportunity cost | -0.878 | -0.878 | -0.878 | -0.878 | -0.878 | -0.878 | -0.878 | -0.878 | -0.878 | -0.878 | |
Total cash flow | -26.19 | 4.60 | 4.60 | 4.60 | 4.60 | 4.60 | 4.60 | 4.60 | 4.60 | 4.60 | 6.79 |
We will now compute the IRR. Note that IRR is the rate which makes NPV as nil.
Year | Total cash flow | 1+r | PVIF | PV = cash flow * PVIF |
0 | -26.19 | 1.1247 | 1.00 | -26.19 |
1 | 4.60 | 0.89 | 4.09 | |
2 | 4.60 | 0.79 | 3.64 | |
3 | 4.60 | 0.70 | 3.24 | |
4 | 4.60 | 0.62 | 2.88 | |
5 | 4.60 | 0.56 | 2.56 | |
6 | 4.60 | 0.49 | 2.27 | |
7 | 4.60 | 0.44 | 2.02 | |
8 | 4.60 | 0.39 | 1.80 | |
9 | 4.60 | 0.35 | 1.60 | |
10 | 6.79 | 0.31 | 2.10 | |
NPV | 0.0000 |
Thus IRR = 1.1247 - 1 = 12.47%
Caspian Sea Drinks is considering the production of a diet drink. The expansion of the plant...
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 $25.00 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 $1.21 million at the beginning of the project and will be recovered at the end. The new...
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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 $24.00 million. The plant and equipment will be depreciated over 10 years to a book value of $2.00 million, and sold for that amount in year 10. Net working capital will increase by $1.34 million at the beginning of the project and will be recovered at the end. The new...
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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 $23.00 million. The plant and equipment will be depreciated over 10 years to a book value of $2.00 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...
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