Question

Caspian Sea Drinks is considering the production of a diet drink. The expansion of the plant and the purchase of the equipment necessary to produce the diet drink will cost $22.00 million. The plant and equipment will be depreciated over 10 years to a book value of $3.00 million, and sold for that amount in year 10. Net working capital will increase by $1.34 million at the beginning of the project and will be recovered at the end. The new diet drink will produce revenues of $9.35 million per year and cost $1.76 million per year over the 10-year life of the project. Marketing estimates 13.00% of the buyers of the diet drink will be people who will switch from the regular drink. The marginal tax rate is 23.00%. The WACC is 12.00%. Find the IRR (internal rate of return).

Answer 1

Here the percentage of Buyer shifts is irrelavent for the calculation of the IRR

Caalculation of the Operating Free cash flows :-

Depreciation =( 22 m - 3 m) /10 = 1.9 million per year

particulars	amount
Revenue	9,350,000
Less- Cost	1,760,000
Less- Depreciation	1,900,000
Profit before tax	5,690,000
Less -Tax@23%	1308700
profit after tax	4,381,300
Add- Depreciation	1,900,000
Operating free cash flows	6,281,300

At the end of 10th year

Book value of Machinery = 3,000,000

Sale value =3,000,000

There is no gain on machinery sale.

Terminal cash inflows at end of 10th year = 3,000,000 + Recovered in NWC = 3,000,000 + 1,340,000

Terminal cash inflows at end of 10th year = 4,340,000

Initial investment = cost of machine + increase in NWC

initial investment = 22,000,000 + 1,340,000 =  $ 23,340,000

Calcualtion of IRR :-

NPV at 12% = [ 6,281,300 * PVAF(12%,10years) + 4,340,000 * PVF ( 12%,10years)] - 23,340,000

NPV at 12% = 13,548,109.76

NPV at 12% is positive ,So we taken another rate is 25%

NPV at 25% = [ 6,281,300 * PVAF(25%,10years) + 4,340,000 * PVF ( 25%,10years)] - 23,340,000

NPV at 25% = - 446,593.86

Calculation of IRR:-

IRR = Lower rate + [NPV at lower rate / ( NPV at lower rate - NPV at higher rate)] * (higher rate - lower rate)

= 12% + [ 13,548,109.76 / ( 13,548,109.76 - (-446,593.86))] * ( 25% -12%)

IRR = 24.589%