Question

Rocket Fuels has a chain of gas stations and is considering investing in a project to add ethanol fuels to its product range.

Here is some information related to this project:

1. Rocket Fuels estimates they can sell 1 Million gallons of ethanol fuel the first year, and then an increase of 10% in sales per year for years 2, 3, and 4. They can’t estimate the sales after the fourth year, there will be elections at that point and the economic climate for ethanol may not be favorable.
2. The average price at which they can sell the ethanol is $2.25 per gallon for year 1, and then an increase of 5 cents per gallon every year.
3. The average material cost per gallon is $1.90 in year 1, growing at 3% per year; the average labor cost per gallon is $0.2 in year 1, growing at 3% per year.
4. Rocket Fuels invested $40,000 in a feasibility study to look at the market for ethanol fuels.
5. Rocket Fuels conducted a research and development project experimenting with a new blend of higher octane ethanol fuel, the cost of the project was $60,000.
6. They will need to acquire a license for production that will cost them $0.05 per gallon of ethanol fuel sold.
7. The company will have to invest $180,000 in new ethanol fuel reservoirs and pumps; they will have no residual value at the end of the project. The company uses straight line depreciation.
8. The company will be taxed at 21%.
1. The current government is encouraging ethanol production and sales; the company will receive a tax credit of 5 cents per each gallon sold.
10. The company uses a working capital requirement of 15% of sales.
11. The company will finance the project with 30% debt, for which the bank expects a rate of return of 8.44%, and 70% equity, for which the owners expect a return of 10%.

Given this set of data, please answer the following questions. Each question is worth 20 points.

1. Identify sunk costs
2. Calculate EBIT per year and tax liability per year (present negative numbers in red or parenthesis)
3. Calculate annual cash flows generated by the project
4. Calculate WACC (round to the nearest whole number)
5. Calculate Net Present Value of the project
6. Calculate Discounted Payback Period and Profitability Index
7. Would you recommend this project to be implemented?
8. What if Rocket Fuels would not benefit from the tax credit, would you still do this project?
9. Would you still do the project if the cost of labor increased by 5% per year?
10. Would you still do the project if WACC were 19%?

Answer 1