Question

United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would require use of an existing warehouse, which is currently rented out to a neighboring firm. The next year’s rental charge on the warehouse is $140,000, and thereafter, the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.44 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and equipment in year 8 for $480,000. Finally, the project requires an immediate investment in working capital of $390,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Working capital will be run down to zero in year 8 when the project shuts down. Year 1 sales of hog feed are expected to be $5.00 million, and thereafter, sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 25%. The cost of capital is 12%.

If the internal rate of return of this project is 19%, based on the IRR criteria would you accept or reject this project. Show your work and explain.

Answer 1

We will accept the project since IRR is greater than the cost of capital.

If the opportunity cost (i.e, the rent ) is considered, IRR will be different.

Workings below