Question

Tatum Inc. is considering expanding into the sports drink business with a new product. Assume that you were recently hired as assistant to the director of capital budgeting and you must evaluate the new project.

The sports drink would be produced in an unused building adjacent to Tatum’s Texas plant; Tatum owns the building, which is fully depreciated. The required equipment would cost $850,000, plus an additional $150,000 for shipping and installation. In addition, inventories would increase by $75,000, while accounts payable would increase by $25,000. All of these costs would be incurred today. The equipment will be depreciated by the straight-line method over the life of the project.

The project is expected to operate for 10 years, at which time it will be terminated. The cash inflows are assumed to begin one year after the project is undertaken and to continue until the end of the tenth year. At the end of the project’s life, the equipment is expected to have a salvage value of $150,000.

Unit sales are expected to total 200,000 units per year, and the expected sales price is $5.00 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Tatum’s tax rate is 40%, and its WACC is 12%. Tentatively, the sports drink project is assumed to be of equal risk to Tatum’s other assets. You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or

Required:

a) Using net present value recommend whether or not Tatum should purchase the new equipment.

b) Determine the payback period for this project.

c) Determine the internal rate of return for the purchase of the equipment.

Answer 1

In order to calculate the NPV or IRR of the project, we first need to calculate the cashflows associated with the projected.

Steps would be -

1. Calculate Initial Investment (Total equipment Cost + Shipping & Installation Cost + Working Capital Investment)

Working Capital Investment = Increase in Current Assets ($75,000) - Increase in Current liabilities ($25,000)

2. Calculate per year cashflow when sales start

2. Calculate the post tax salvage value at year 10 (Pretax salavage value * (1 - tax rate)

a) Now, NPV is the present value of all cashflows associated with the project. It is, for this project, equal to $561,040. A positive NPV indicates value added from project and hence based on NPV, this project should be accepted.

b) Payback is the number of years taken by the cash inflows to re-earn the invested amount.

In this question, in 3 years, company earns $840,000 ($280,000 * 3). It needs $210,000 more to re-earn the invested amount of $1,050,000.

Now, in year 4 they are earning $280,000. So, time taken to earn $210,000 = 210,000/280,000 = 0.75

Hence payback = 3 Years + 0.75 year = 3.75 years

(c) IRR is the rate of return when NPV is equal to zero. This is calculated by Excel function. (it is almost impossible to calculate IRR manually. You need Excel or financial calculator for the same.) All the cashflows are put in as arguments in the excel function "IRR".