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 $2.01 million fully installed and has a 10 year life. It will be depreciated to a book value of $239,157.00 and sold for that amount in year 10.

b. The Engineering Department spent $29,939.00 researching the various juicers.

c. Portions of the plant floor have been redesigned to accommodate the juicer at a cost of $19,763.00.

d. The PJX5 will reduce operating costs by $478,030.00 per year.

e. CSD’s marginal tax rate is 35.00%.

f. CSD is 61.00% equity-financed.

g. CSD’s 10.00-year, semi-annual pay, 6.26% coupon bond sells for $1,017.00.

h. CSD’s stock currently has a market value of $22.00 and Mr. Bensen believes the market estimates that dividends will grow at 4.31% forever. Next year’s dividend is projected to be $1.51.

Answer 1

Note :- Here The Engineering Department spent $29,939.00 researching the various juicers is sunk cost. So, it is not to consider the cash outflows for calculation of NPV.

Calculation of the initial cash outlay:-

Initial investment = cost of machine +cost of redesigned of floor for machine

Initial investment = $ 2,010,000 + $ 19,763 = $ 2,029,763

Calculation annual depreciation amount :-

Depreciation =( Cost of machine - salvage value )/ no of year of machinery life

Depreciation = (2,010,000 - 239,157) / 10 year = $ 177,084.3 per year.

Calculation of the annual cost savings :-

The PJX5 will reduce operating costs by $478,030.00 per year. That means increase in PBT . That means we pay extra tax .

Saving in operating cost after tax = $ 478,030 * ( 1- tax rate )

= $ 478,030 * ( 1 - 0.35) =$ 310,719.5

Tax shield on depreciation = depreciation * tax rate

= 177,084.3 * 0.35 = $ 61,979.5

Annual cost savings after tax = 310,719.5 + 61,979.5 = $ 372,699.00

The cash inflows are discounted at WACC rate.

Calculation of the weighted average cost of capital:-

Cost of debt =[ interest amount ( 1- tax rate) + ( redemption value - net proceeds)/ n ] / ( Redemption value + net proceeds ) / 2

Cost of debt = [ 62.6( 1 - 0.35) + ( 1000 - 1017)/ 10] ( 1000+ 1017)/2 = 3.87%

Cost of debt after tax = 3.87%

Cost of equity =( D​​​​​​1 / market price ) + g

= 1.51/ 22 + 0.0431 = 11.17%

weight of equity = 0.61

Weight of debt = 1- weight of equity = 1- 0.61 = 0.39

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

WACC = 3.87% * 0.39 + 11.17* 0.61 = 8.32%

Calculation of NPV of the project :-

Cash inflows = annual saving in cost

Cash flows upto 9 years is constant that is $ 372,699 per year.

Cash flow in 10 th is annual cost savings after tax plus sale of machinery cost = 372,699 + 239,157 = $ 611,856

Present value of cash inflows = 372,699 * PVAF ( 9 years , 8.32 %) + ( 372,699 + 239,157) *PVF ( 10 years, 8.32%)

= 372,699 * [ 1- (1+0.0832)-9] / 0.0832 + 611,856 * (1/ (1+0.0832)10)

Present value of cash inflows= $ 2,297,543.75 +$ 275,145.69

Present value of cash inflows= $ 2,572,689.44

NPV. = Present value of cash inflows - initial investment

NPV = $ 2,572,689.44 - $ 2,029,763 = $ 542,926.44