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 NPV of the PJX5?

a. The PJX5 will cost $2.38 million fully installed and has a 10 year life. It will be depreciated to a book value of $192,598.00 and sold for that amount in year 10.

b. The Engineering Department spent $14,017.00 researching the various juicers.

c. Portions of the plant floor have been redesigned to accommodate the juicer at a cost of $24,605.00.

d. The PJX5 will reduce operating costs by $415,751.00 per year.

e. CSD’s marginal tax rate is 33.00%.

f. CSD is 75.00% equity-financed.

g. CSD’s 17.00-year, semi-annual pay, 6.96% coupon bond sells for $1,005.00.

h. CSD’s stock currently has a market value of $23.98 and Mr. Bensen believes the market estimates that dividends will grow at 2.58% forever. Next year’s dividend is projected to be $1.60.

Answer 1

Cost of equity can be calculated by using Gordon growth model

r=(D1/P0)+g

r=(1.6/23.98)+2.58%

r=9.25%

Cost of debt can be calculated by RATE function in Excel

Coupon rate= 6.96%

Yearly coupon payment=(6.96%*$1000)=$69.6

Semi annual payment=$69.6/2=$34.8

number of periods=17 years*2=34 periods

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

=RATE(34,34.8,-1005,1000,0,0)

=3.455%

semi annual yield =3.455%

annaul yield=3.455%*2=6.91%

Cost fo debt=6.91%

after tax cost of debt=6.91%*(1-tax rate)=6.91%*(1-33%)=4.629%

weightage of equity in capital structure= 75% and debt will be 25%

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

=(0.75*9.25%)+(0.25*4.629%)

=8.095%

Total cost=$2380000+24605=2404605

We should not take research expenses as they are called as sunk costs and which are unavoidable though if you have not take up the project

NPV(8.095%,Year1 toYear10 cashinflows)-Total cost

NPV(8.095%,Year1 toYear10 cashinflows)-2404605

NPV=-$1915.41, they should reject this project as NPV is negative