Question

McCormick & Company is considering a project that requires an initial investment of $24 million to build a new plant and purchase equipment. The investment will be depreciated as a modified accelerated cost recovery system (MACRS) seven-year class asset. The new plant will be built on some of the company's land, which has a current, after-tax market value of $4.3 million. The company will produce bulk units at a cost of $130 each and will sell them for $420 each. There are annual fixed costs of $500 thousand. Unit sales are expected to be $150,000 each year for the next six years, at which time the project will be abandoned. At that time, the plant and equipment is expected to be worth $8 million (before tax) and the land is expected to be worth $5.4 million (after tax). To supplement the production process, the company will need to purchase $1 million worth of inventory. That inventory will be depleted during the final year of the project. The company has $100 million of debt outstanding with a yield to maturity of 8 percent, and has $150 million of equity outstanding with a beta of 0.9. The expected market return is 13 percent, and the risk-free rate is 5 percent. The company's marginal tax rate is 40 percent.

6. Create an after-tax cash flow timeline.

7. What are the total expected cash flows at the end of year six? The $4.3 million is an opportunity cost and must be included at date 0 as a cash outflow. If the project is accepted, however, the land can be sold in six years for $5.4 million.

8. Find the NPV using the after-tax WACC as the discount rate.

9. Find the IRR.

10. Should the project be accepted? Discuss whether NPV or IRR creates the best decision rule.

Answer 1

Particulars	(Amount In $Millions)
Cost of Initial Investment(Plant &Machinery)	24
Inventory purchase	1
Land(Opportunity cost)	4.3
Total outflow	29.3

Details	Yr 1	2	3	4	5	6
MACR rate(%)	14.29	24.49	17.49	12.49	8.93	8.92
Depreciation	3.4296	5.8776	4.1976	2.9976	2.1432	2.141
At Yr 6 end
Book value	3.2136
Market value	8
Profit	4.7864
Tax @ 20%	0.95728
Sale value after tax	3.82912

Cost of equity = 5+0.9*8 = 12.2%

Cost of Debt = 8

Equity 150

Debt 100

WACC =150/250*12.2*100/250* 8/100 =10.52%

Year	Details	Cash Flows	Discount Factor	Present value
1 to 6	Profit after tax	17.2	4.2897	73.78284
6	P&M sale value after tax	3.82912	0.548724994	2.10113385
6	Land Sale after tax	5.22	0.548724994	2.86434447
0	Outflow			-29.3
	Net present value			49.4483183

Since NPV is positive Project should be accepted