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 $2.20 million fully installed and has a 10 year life. It will be depreciated to a book value of $243,320.00 and sold for that amount in year 10.

b. The Engineering Department spent $39,147.00 researching the various juicers.

c. Portions of the plant floor have been redesigned to accommodate the juicer at a cost of $20,225.00.

d. The PJX5 will reduce operating costs by $453,365.00 per year.

e. CSD’s marginal tax rate is 33.00%.

f. CSD is 68.00% equity-financed.

g. CSD’s 14.00-year, semi-annual pay, 5.80% coupon bond sells for $978.00.

h. CSD’s stock currently has a market value of $23.87 and Mr. Bensen believes the market estimates that dividends will grow at 2.46% forever. Next year’s dividend is projected to be $1.45.

round to 2 decimals

Answer 1

WACC

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

weight of debt = (1 - weight of equity) = (1 - 68%) = 32%

after-tax cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 14*2 (14 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 5.8% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -978 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE calculated is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 6.035%

after-tax cost of debt = YTM * (1 - tax rate)

after-tax cost of debt = 6.035% * (1 - 33%) ==> 4.0434%

cost of equity = (next year dividend / current share price) + constant growth rate

cost of equity = ($1.45 / $23.87) + 0.0246 = 8.5346%

WACC = (32% * 4.0434%) + (68% * 8.5346%) = 7.0974%

NPV analyis

Operating cash flow (OCF) each year = incremental income after tax + depreciation

The redesign of plant floor is added to the installed cost of the juicer as it is a capital expenditure. The total depreciable cost = installed cost of juicer + cost of redesign of plant floor.

Depreciation each year = (total depreciable cost - salvage value) / depreciable life = ($2,220,225 - $243,320) / 10 = $197,691

The amount spent by Engineering Department on research is a sunk cost because it is a historical cost, and is not recoverable. It is not incremental to acceptance of the project. Hence, it should not be considered in the cash flow analysis.

The salvage value of the juicer at the end of 10 years equals its book value at the end of 10 years. Hence, there is no tax adjustment required.

NPV is calculated using NPV function in Excel

NPV is $446,612.38