Question

Two years ago the Krusty Krab Restaurant purchased a grill for $50,000. The owner, Eugene Krabs, has learned that a new grill is available that will cook Krabby Patties twice as fast as the existing grill. This new grill can be purchased for $60,000 and would be depreciated straight line over 8 years, after which it would have no salvage value. Eugene Krab expects that the new grill will produce EBITDA of $50,000 per year for the next eight years while the existing grill produces EBITDA of only $35,000 per year. The current grill is being depreciated straight line over its useful life of 10 years after which it will have no salvage value. All other operating expenses are identical for both grills. The existing grill can be sold to another restaurant now for $30,000. The Krusty Krab's tax rate is 20%.

If in the following tasks a number should be stated with negative sign, enter a minus sign "-" before the number. Don't use a comma as a thousand separator for the results.

a. The incremental free cash flow that the Krusty Krab will incur today (Year 0) if they elect to upgrade to the new grill is $. (round to the nearest dollar)

b. The incremental free cash flow that the Krusty Krab will incur in year 1 if they elect to upgrade to the new grill is $. (round to the nearest dollar)

c. If the Krusty Krab's opportunity cost of capital is 6%, then the NPV for upgrading to the new grill is $. (round to the nearest dollar)

d. The IRR for upgrading to the new grill is %. (round to one decima

Answer 1

a]	Cost of the new grill		$        60,000
	Sale value of the old grill	$         30,000
	Book value of the old grill [(50000/10)*8]	$         40,000
	Loss on sale	$         10,000
	Tax shield on loss at 20%	$           2,000
	After tax sale value of old grill [30000+2000]		$       -32,000
	Incremental FCF at t0		$        28,000
b]	Incremental EBITDA [50000-35000]	$         15,000
	Incremental depreciation [7500-5000]	$           2,500
	Incremental NOI	$         12,500
	Tax at 20%	$           2,500
	Incremental NOPAT	$         10,000
	Add: Incremental depreciation	$           2,500
	Incremental FCF, Years 1 to 8	$         12,500
c]	PV of FCF = 12500*(1.06^8-1)/(0.06*1.06^8) =	$         77,622
	Less: Initial investment	$         28,000
	NPV	$         49,622
d]	IRR is that discount rate for which NPV = 0.
	Hence, for the project,
	0 = -28000+12500*PVIFA(irr,8)
	PVIFA(irr,8) = 28000/12500 =	2.2400
	PVIFA for n = 8 and r = 42% = 2.2369
	PVIFA for n = 8 and r = 41% = 2.2829
	IRR = 41%+1%*(2.2829-2.24)/(2.2829-2.2369) =	41.93%