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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 $23.00 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 diet drink will produce revenues of $8.65 million per year and cost $2.37 million per year over the 10-year life of the project. Marketing estimates 20.00% of the buyers of the diet drink will be people who will switch from the regular drink. The marginal tax rate is 33.00%. The WACC is 15.00%. Find the IRR (internal rate of return)

Solutions

Expert Solution

Profit = (revenues-variable cost)*(1-switch %)
=(8650000-2370000)*(1-0.2)
=5024000
Time line 0 1 2 3 4 5 6 7 8 9 10
Cost of new machine -23000000
Initial working capital -1210000
=Initial Investment outlay -24210000
100.00%
Profits 5024000 5024000 5024000 5024000 5024000 5024000 5024000 5024000 5024000 5024000
-Depreciation (Cost of equipment-salvage value)/no. of years -2200000 -2200000 -2200000 -2200000 -2200000 -2200000 -2200000 -2200000 -2200000 -2200000 1000000 =Salvage Value
=Pretax cash flows 2824000 2824000 2824000 2824000 2824000 2824000 2824000 2824000 2824000 2824000
-taxes =(Pretax cash flows)*(1-tax) 1892080 1892080 1892080 1892080 1892080 1892080 1892080 1892080 1892080 1892080
+Depreciation 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000
=after tax operating cash flow 4092080 4092080 4092080 4092080 4092080 4092080 4092080 4092080 4092080 4092080
reversal of working capital 1210000
+Proceeds from sale of equipment after tax =selling price* ( 1 -tax rate) 670000
+Tax shield on salvage book value =Salvage value * tax rate 330000
=Terminal year after tax cash flows 2210000
Total Cash flow for the period -24210000 4092080 4092080 4092080 4092080 4092080 4092080 4092080 4092080 4092080 6302080
Discount factor= (1+discount rate)^corresponding period 1 1.116310645 1.246149456 1.391089902 1.5528885 1.7335059 1.9351311 2.160207464 2.4114626 2.691941355 3.005043
Discounted CF= Cashflow/discount factor -24210000 3665717.978 3283779.471 2941635.903 2635141 2360580.3 2114626.7 1894299.538 1696928.7 1520122.269 2097168
NPV= Sum of discounted CF= 0.00
IRR is discount rate at which NPV = 0 = 11.63%

jeff jeffy answered 6 months ago
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