Question

As a senior vice president of a major consumer products corporation, you have been asked to review the following investment and advise the CEO whether it should be pursued. The investment involves buying a bottle manufacturer and making it a subsidiary of your beer division. The acquisition will benefit the firm by providing a reliable internal source of bottles. The acquisition price will be $3,500,000. The bottle company has tangible assets of $2,500,000 and debt of $1,000,000 which must be paid off by the parent corporation (for a total of $4,500,000 in cash outlays). If the transaction occurs, the beer division will also acquire an intangible asset of $2,000,000 to reflect the premium paid for the bottler. That intangible asset must be amortized over five years, resulting in an expense of $400,000 per year. The company will also have depreciation expense of $200,000 per year for the next ten years on the bottler's property, plant, and equipment. No new equipment will need to be purchased during the operating life of the bottling plant. The company would have to make some changes at the bottling plant in the first year following the acquisition to optimize it for producing bottles for its beer plant. Those changes will cost $300,000 (and will be expensed immediately).

            On the plus side, the bottling plant will produce 20 million bottles per year at a variable cost of $0.12 per bottle and a fixed outlay cost of $1,500,000 per year. Currently, the beer division pays $0.25 per bottle and has sufficient volume that it can use as many bottles as the bottling plant can produce. The bottling plant is expected to operate for ten years following acquisition before it becomes obsolete. At that point, it can be scrapped and the land sold, yielding $1,000,000 (received in December 2028), for a gain on sale of $500,000.

            If the firm buys the bottler, the transaction will take place on December 31, 2018, with the new operations affecting the company starting in 2019. By convention, costs and benefits received throughout a year are treated for present value purposes as occurring at the end of that year. There are no taxes and the firm's discount rate is 10 percent.

Question:

Determine the net present value and NPVI for the corporation if it buys the bottling company. (Use 2018 as year 0.)

*Make sure solution is detailed and can be seen clearly.*

Answer 1

Computation of NPV:

Year	0	1	2	3	4	5	6	7	8	9	10
initial Cash outflow	(4,500,000)
Sales revenue		5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000
Less: variable cost		(2,400,000)	(2,400,000)	(2,400,000)	(2,400,000)	(2,400,000)	(2,400,000)	(2,400,000)	(2,400,000)	(2,400,000)	(2,400,000)
Less: fixed cost		(1,500,000)	(1,500,000)	(1,500,000)	(1,500,000)	(1,500,000)	(1,500,000)	(1,500,000)	(1,500,000)	(1,500,000)	(1,500,000)
Less: Cost of optimizing the plant		(300,000)
Add: sale of land											1,000,000
Net cash flows		800,000	1,100,000	1,100,000	1,100,000	1,100,000	1,100,000	1,100,000	1,100,000	1,100,000	2,100,000
Discounting factor at 10%	1	0.90909091	0.826446281	0.751314801	0.683013455	0.620921323	0.56447393	0.513158118	0.46650738	0.424097618	0.385543289
PV of cash flows	(4,500,000)	727,272.73	909,090.91	826,446.28	751,314.80	683,013.46	620,921.32	564,473.93	513,158.12	466,507.38	809,640.91
NPV	2,371,840

Here, the NPV is positive, that means this is a beneficial transaction.
Now, let us calculate the NPVI or RI:
The calculation of RI involves both the effect of the transaction on profit and the effect on investment (assets).
That means: In year 1, we can see the increase in operating cash flow = $800,000
Less: depreciation = $200,000
Less: goodwill amortization = $400,000
Thus, the net profit = $200,000
And for effect in assets, we have :
Assets = $4.5 million initial book value less depreciation and amortization
= 4.5million - 200,000-400,000 = $3.9 million
Therefore, RI = net profit * (Asset* cost of capital)
here ,the cost of capital is 10 percent
RI = 200,000 - 0.1 * 3.9 million = ($190,000) is a reduction in RI.

Given that the operations affecting the company starting in 2019:
That means the promotion decision must be made before the end of year 2.
The operating cash flow increases to $1.1 million
assets (net book value) = 3.9million - 200,000-400,000 = $3.3 million
In year 2: RI = net profit * (Asset* cost of capital)
= $1.1 million - (0.1* $3.3million) = $170,000
Therefore, RI becomes positive in year 2.
Thus, if we calculate for year3 , 4 , etc. the results will be even better.
Therefore, if you consider your long-run incentives, you might still recommend the acquisition.