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 $1.61 million fully installed and has a 10 year life. It will be depreciated to a book value of $128,641.00 and sold for that amount in year 10.

b. The Engineering Department spent $25,981.00 researching the various juicers.

c. Portions of the plant floor have been redesigned to accommodate the juicer at a cost of $21,389.00.

d. The PJX5 will reduce operating costs by $314,965.00 per year.

e. CSD’s marginal tax rate is 24.00%.

f. CSD is 66.00% equity-financed.

g. CSD’s 12.00-year, semi-annual pay, 6.69% coupon bond sells for $1,002.00.

h. CSD’s stock currently has a market value of $23.58 and Mr. Bensen believes the market estimates that dividends will grow at 4.09% forever. Next year’s dividend is projected to be $1.48.

Answer 1

Cost of equity can be calculated by using Gordon growth model

r=(D1/P0)+g

r=(1.48/23.58)+4.09%

r=10.367%

Cost of debt can be calculated by RATE function in Excel

Coupon rate= 6.69%

Yearly coupon payment=(6.69%*$1000)=$66.9

Semi annual payment=$66.9/2=$33.45

number of periods=12 years*2=24 periods

=RATE(nper, pmt,pv,fv,type, guess)

=RATE(24,33.45,-1002,1000,0,0)

=3.333%

semi annual yield =3.333%

annaul yield=3.333%*2=6.67%

Cost fo debt=6.67%

after tax cost of debt=6.67%*(1-tax rate)=6.67%*(1-24%)=5.07%

weightage of equity in capital structure= 66% and debt will be 34%

Cost of capital=(weight of equity*cost of equity)+(weight of debt* after tax cost of debt)

=(0.66*10.367%)+(0.34*5.07%)

WACC=8.56%

IRR>WACC (11.32%>8.56%). Hence, we should accept the project