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 IRR of the PJX5?

a. The PJX5 will cost $1.59 million fully installed and has a 10 year life. It will be depreciated to a book value of $275,753.00 and sold for that amount in year 10.

b. The Engineering Department spent $34,697.00 researching the various juicers.

c. Portions of the plant floor have been redesigned to accommodate the juicer at a cost of $17,634.00.

d. The PJX5 will reduce operating costs by $419,758.00 per year.

e. CSD’s marginal tax rate is 32.00%.

f. CSD is 55.00% equity-financed.

g. CSD’s 17.00-year, semi-annual pay, 6.28% coupon bond sells for $966.00.

h. CSD’s stock currently has a market value of $21.36 and Mr. Bensen believes the market estimates that dividends will grow at 2.73% forever. Next year’s dividend is projected to be $1.77.

Answer format: Percentage Round to: 2 decimal places

thanks!

Answer 1

Solution:

1) Calculation of after-tax savings per year.

Particulars	Amount ($)
1) Reduction in operating costs	419,758
Less: Depreciation per Year (15,90,000 - 275,753) / 10	131,424.70
2) Savings before tax	288,333.30
Less: Tax @ 0.32	92,266.65
3) Savings after tax	196,066.65
Add: Depreciation	131,424.70
4) Cash savings per year for 10 Years	327,491.35

Assumption: It has been assumed that depreciation is on the straight-line method & plant floor redesigned expenses is not be capitalised.

2) Initial cash outflow:

Particulars	Amount ($)
Cost of PJX5	15,90,000
R&D Exp.	34,697
Floor setting Exp.	17,634
Total	16,42,331

3) Calculation of cost of capital (Kc)

Post-tax cost of debt = Kd * (1-t) = 6.28 * 0.68 = 4.27%

Post-tax cost of equity

Ke = (D1 / Price + Growth) * 100

= (1.77 / 21.36 + .0273) * 100

= 11.01%

Weight of Equity = 55% , Weight of Debt =45%

Kc = 0.55 * 11.01 + 0.45*4.27

= 7.97%

4) Calculation of NPV = Present value of savings after tax discounted at 7.97% - Initial investment

= 327,491.34 * PVAF(7.97%, 10) - 16,42,331

= 22,00,470.17 - 16,42,331

=$ 5,58,139.17

At IRR, NPV =0

As the NPV is positive, IRR is more than cost of capital

Let's assume IRR to be 14%, then

NPV =  327,491.34 * PVAF(14%, 10) - 16,42,331

= 17,08,232.7 - 16,42,331

=$ 65,901.7

As NPV is still positive IRR is more than 14%

Let's assume IRR to be 15% then

NPV =  327,491.34 * PVAF(15%, 10) - 16,42,331

= 16,43,603.26 - 16,42,331

=$ 1,272.26

As at 15% outflows equals approximate to inflows

IRR is 15.02% approximately.