Question

Suppose you are a capital budgeting expert in a consulting company. Your potential client,the Sun Devil Cookie Company, is considering the construction of a bakery to produce a newtype of chocolate chip cookie that is free of both cholesterol and saturated fat and has 2 caloriesper cookie. The bakery is expected to last for 25 years. Its initial cost is $80 million. This costcan be depreciated over 15 years in nominal terms using straight line depreciation to a valueof zero. After 15 years the bakery needs to be renovated. The cost of renovation will be $20million in real terms and can be depreciated (again using straight line depreciation to a valueof zero) over the remaining 10 years of the bakery’s life. The salvage value of the equipment atthe end of the project will be $1 million in real terms. The land the bakery is built on couldbe rented out for $1.25 million a year in real terms for 25 years with the rent collected at thebeginning of each year.The bakery will be able to produce 25 million packets of cookies per year. The price of apacket of cookies is currently $2.75. It is expected to grow at a rate of 5% per year in realterms for the first 2 years, then at 2% per year in real terms for 4 years, and finally at 0% peryear thereafter for the remainder of the bakery’s life. The basic ingredients for a package ofcookies currently cost $0.75. These costs are expected to grow by 1% in real terms through thelifetime of the project. The labor required to operate the bakery is expected to cost a total of$11 million dollars in nominal terms during the first year and this is expected to increase at 4%in real terms thereafter. The level of working capital for the project is $18 million at year 0 andthis is expected to increase at 3% in real terms per year. At the end of the project (year 25),the working capital can be fully recovered.The rate of inflation is expected to be 2% per year for the bakery’s life. The firm’s total taxrate including local taxes is 35%. Its opportunity cost of capital for projects of this type is 12%in nominal terms.Prepare an analysis of this capital budgeting problem, in which you compute the Net PresentValue using nominal terms. Pay special attention when converting real terms to nominal terms.Present your answer in a brief memo outlining your valuation. Make sure you state whether thefirm should build the bakery. The technical appendix should include a copy of your spreadsheet and explanations of the formulas you used in your computations.

Answer 1

The Project of Bakery Shall be undertaken as it would give positive NPV of $45.03 Million.

The calculations can be seen in following 3 Pictures.

All the calculations are rounded off in 2 decimal places.