Question

1. Capital budgeting.

Põltsamaa Felix, an exclusive Estonian fruit wine producer, is considering the purchase of 10,000 French oak barrels at a cost of 900 eur each. The investment into barrels is considered a capital expense and would be depreciated straight line over 5 years.

After 4 years, the barrels will be useless for making fine wine, but they expect to be able to sell them for 3.5 million EUR to E & J Gallo, the world largest wine producer. The increase in the quality of its sweet apple line of wines due to the use of the new French oak barrels is expected to increase revenue by 7 million eur (but only) in years 3 and 4. The barrels would have no influence on COGS, SG&A or other operating expenses. The additional working capital investment is 10% of the additional sales revenues and is fully recovered when the project ends (in four years). Note that the investment into working capital is made just before the expected sales increase. The tax rate is 30% (profits are taxed), and the required return is 14%.

1. Construct the capital budget
2. Evaluate the project on the basis of NPV and MIRR.

Answer 1

Capital Budget
Year	0	1	2	3	4
Cost	-€ 90,00,000
Increase Revenue		€ 0	€ 0	€ 70,00,000	€ 70,00,000
Working capital			-€ 7,00,000	€ 0	€ 7,00,000
Cash flow from operation		€ 0	-€ 7,00,000	€ 70,00,000	€ 77,00,000
Depreciation		-€ 18,00,000	-€ 18,00,000	-€ 18,00,000	-€ 18,00,000
Cash flow after Depreciation		-€ 18,00,000	-€ 25,00,000	€ 52,00,000	€ 59,00,000
Profit on sales of barrels					€ 17,00,000
Cash flow before tax		-€ 18,00,000	-€ 25,00,000	€ 52,00,000	€ 76,00,000
Tax(30%)		€ 5,40,000	€ 7,50,000	-€ 15,60,000	-€ 22,80,000
Net cash flow after tax		-€ 12,60,000	-€ 17,50,000	€ 36,40,000	€ 53,20,000
Add back depreciation		€ 18,00,000	€ 18,00,000	€ 18,00,000	€ 18,00,000
Net cash from operation	-€ 90,00,000	€ 5,40,000	€ 50,000	€ 54,40,000	€ 71,20,000
Discount rate	14%
NPV	-€ 6,00,385.79	NPV(14%,C15:F15)+B15
MIRR	12%	MIRR(B15:F15,0.14,0.14)

for reference of excel formula

Analysis :

Company should reject the project on criteria of NPV and MIRR

• NPV< 0 , negative
• MIRR < 14% ( required cost of investment)