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 $1.61 million fully installed and has a 10 year life. It will be depreciated to a book value of $152,211.00 and sold for that amount in year 10. b. The Engineering Department spent $17,423.00 researching the various juicers. c. Portions of the plant floor have been redesigned to accommodate the juicer at a cost of $22,211.00. d. The PJX5 will reduce operating costs by $416,997.00 per year. e. CSD’s marginal tax rate is 26.00%. f. CSD is 60.00% equity-financed. g. CSD’s 20.00-year, semi-annual pay, 6.59% coupon bond sells for $1,038.00. h. CSD’s stock currently has a market value of $22.91 and Mr. Bensen believes the market estimates that dividends will grow at 3.64% forever. Next year’s dividend is projected to be $1.47. Please show how to get cash flows and IRR

Answer 1

Step 1: Calculate Initial Cost and Annual Cash Flows

The value of initial cost and annual cash flows is arrived as below:

Initial Cost = -(Installated Cost of Juicer + Cost Incurred to Redesign Plant Floor) = -(1,610,000 + 22,211) = -$1,632,211

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Cash Flow (Year 1 to Year 9) = (Annual Savings - Depreciation)*(1 - Tax Rate) + Annual Depreciation

where Annual Savings = $416,997, Depreciation = (Total Initial Cost - Salvage Value)/Estimated Life = (1,632,211 - 152,211)/10 = $148,000 and Tax Rate = 26%

Using these values in the above formula, we get,

Cash Flow (Year 1 to Year 9) = (416,997 - 148,000)*(1 - 26%) + 148,000 = $347,057.78

Annual Cash Flow Year 10 = 347,057.78 + After-Tax Salvage Value = 347,057.78 + 152,211*(1 - 26%) = $459,693.92

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Step 2: Calculate IRR

IRR is the minimum rate of return acceptable from a project. It can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The basic formula for calculating IRR is given as below:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4 + Cash Flow Year 5/(1+IRR)^5 + Cash Flow Year 6/(1+IRR)^6 + Cash Flow Year 7/(1+IRR)^7 + Cash Flow Year 8/(1+IRR)^8 + Cash Flow Year 9/(1+IRR)^9 + Cash Flow Year 10/(1+IRR)^10

IRR is calculated with the use of EXCEL as follows:

where

IRR = IRR(B2:B12) = 17.13%

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Notes:

1) The research cost of $17,423 is a sunk cost. This cost was incurred irrespective of whether the company decides to purchase any juicer. So, the research cost will not be included in the initial cost.

2) The cost of redesigning ($22,211) the plant will be included in the initial cost as it was necessary to make the juicer functional/operational.