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 $1.60 million fully installed and has a 10 year life. It will be depreciated to a book value of $118,230.00 and sold for that amount in year 10.

b. The Engineering Department spent $16,293.00 researching the various juicers.

c. Portions of the plant floor have been redesigned to accommodate the juicer at a cost of $18,572.00.

d. The PJX5 will reduce operating costs by $313,302.00 per year.

e. CSD’s marginal tax rate is 33.00%.

f. CSD is 73.00% equity-financed.

g. CSD’s 19.00-year, semi-annual pay, 6.62% coupon bond sells for $971.00.

h. CSD’s stock currently has a market value of $23.50 and Mr. Bensen believes the market estimates that dividends will grow at 2.16% forever. Next year’s dividend is projected to be $1.66.

Answer 1

First we will calculate the cost of equity and after tax cost of debt to arrive at the cost of capital rate.

cost of equity can be calculated from Gordon growth model

P0=D1/r-g

r=D1/P0+g

=($1.66/$23.5)+2.16%

=7.06%+2.16%

9.22%

Cost of debt can be calculated by using RATE function in Excel

Coupon rate= 6.62%

Yearly coupon payment=(6.62%*$1000)=$66.2

Semi annual payment=$66.2/2=$33.1

number of periods=19 years*2=38 periods

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

=RATE(38,33.1,-971,1000,0,0)

=3.45%

semi annual yield =3.45%

annaul yield=3.45%*2=6.90%

Cost fo debt=6.90%

after tax cost of debt=6.90%*(1-tax rate)=6.90%*(1-33%)=4.62%

weightage of equity in capital structure= 73% and debt will be 27%

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

=(0.73*9.22%)+(0.27*4.62%)

=7.978%

Initial cost=$1600000+18572=$1618572

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

Year wise cashflows are shown as below

NPV(rate,Year 1to Year 10 cash flows)-Initial cost

NPV(7.978%,Year 1 to year 10 cash flows)-$1618572

$156560.08

NPV is positive , hence we should accept the project