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 $2.27 million fully installed and has a 10 year life. It will be depreciated to a book value of $133,817.00 and sold for that amount in year 10. b. The Engineering Department spent $15,892.00 researching the various juicers. c. Portions of the plant floor have been redesigned to accommodate the juicer at a cost of $23,772.00. d. The PJX5 will reduce operating costs by $492,390.00 per year. e. CSD’s marginal tax rate is 23.00%. f. CSD is 70.00% equity-financed. g. CSD’s 14.00-year, semi-annual pay, 6.21% coupon bond sells for $996.00. h. CSD’s stock currently has a market value of $20.50 and Mr. Bensen believes the market estimates that dividends will grow at 3.94% forever. Next year’s dividend is projected to be $1.54.

Answer 1

Initial investment = $ 2,270,000

Annual depreciaion = $ ( 2,270,000 - 133,817 ) / 10 = $ 213,618

Annual cost savings = $ 492,390

Annual cash flows after taxes = 492,390 x 0.77 + 213,618 x 0.23 = 379,140 + 49,132 = 428,272

PVA 9.46 %, n=10 = 6.2897

PV 9.46 %, n=10 = 0.4050

Present value of cash inflows = 428,272 x 6.2897 + 133,817 x 0.4050 = 2,693,702 + 54,196 = 2,747,898

Net present value = $ ( 2,747,898 - 2,270,000 ) = $ 477,898

IRR : 14 %

The research and the floor redesign costs have already been incurred, and therefore are sunk costs. They are not relevant for decision making.

Cost of Equity :

Let the cost of equity be K e.

Stock price = D1/ ( K e - g )

or 20.50 = 1.54 / ( K e - 0.0394 )

or 20.50 K e - 0.8077 = 1.54

or K e = 0.1145 or 11.45 %

Cost of debt :

Yield to maturity = 6.25 %

After tax cost of debt = 6.25 % * ( 1 - 0.23 ) = 4.81 %

Weighted average cost of capital = 0.1145 * 0.70 + 0.0481 * 0.30 = 0.08015 + 0.01443 = 0.09458 or 9.46 %