Question

Caspian Sea Drinks is considering the purchase of a plum juicer – the PJX5. There is no planned increase in production. The PJX5 will reduce costs by squeezing more juice from each plum and doing so in a more efficient manner. Mr. Bensen gave Derek the following information. What is the IRR of the PJX5?

a. The PJX5 will cost $1.97 million fully installed and has a 10 year life. It will be depreciated to a book value of $204,551.00 and sold for that amount in year 10.

b. The Engineering Department spent $26,274.00 researching the various juicers.

c. Portions of the plant floor have been redesigned to accommodate the juicer at a cost of $20,213.00.

d. The PJX5 will reduce operating costs by $313,001.00 per year.

e. CSD’s marginal tax rate is 38.00%.

f. CSD is 70.00% equity-financed.

g. CSD’s 11.00-year, semi-annual pay, 6.89% coupon bond sells for $1,021.00.

h. CSD’s stock currently has a market value of $23.91 and Mr. Bensen believes the market estimates that dividends will grow at 3.98% forever. Next year’s dividend is projected to be $1.59.

Round to: 2 decimal places

Answer 1

Calculation of discounting rate:

Cost of bond = [Coupon Int * (1 - Tax Rate) + (Face Value - Market Price / Duration)] / (Face Value + Market Price / 2)

= 137.8 * (1 - 0.38) + (1000 - 1021 / 11) / (1000 + 1021 / 2)

= 85.44 - 1.91 / 1010.5

= 83.53 / 1010.5

= 0.0827 or 8.27%

Cost of equity = (Next year dividend / Market Value) + Growth Rate

= (1.59 / 23.91) + 0.0398

= 0.0665 + 0.0398

= 0.1063 or 10.63%

Cost of capital = 8.27 * 30% + 10.63 * 70%

= 2.48 + 7.44

= 9.92%

Initial cost = $1,970,000 + $26,274 + $20,213 = $2,016,487

Cash flows = $313,001

Salvage = $204,551

At IRR, NPV = 0

0 = -$2,016,487 + $313,001 * PVAF (IRR, 10 years) + $204,551 * PVIF (IRR, 10 years)

$2,016,487 = $313,001 * PVAF (IRR, 10 years) + $204,551 * PVIF (IRR, 10 years)

IRR = 9.84%