Question

Sunshine Smoothies Company (SSC) manufactures and distributes smoothies. SSC is considering the development of a new line of high-protein energy smoothies. SSC's CFO has collected the following information regarding the proposed project, which is expected to last 3 years:

• The project can be operated at the company's Charleston plant, which is currently vacant.
• The project will require that the company spend $4.8 million today (t = 0) to purchase additional equipment. This equipment is eligible for 100% bonus depreciation, so the equipment is fully depreciated at the time of its purchase. The company plans to use the equipment for all 3 years of the project. At t = 3 (which is the project's last year of operation), the equipment is expected to be sold for $1,700,000 before taxes.
• The project will require an increase in net operating working capital of $730,000 at t = 0. The cost of the working capital will be fully recovered at t = 3 (which is the project's last year of operation).
• Expected high-protein energy smoothie sales are as follows:

  Year	Sales
  1	$2,100,000
  2	7,900,000
  3	3,200,000

• The project's annual operating costs (excluding depreciation) are expected to be 60% of sales.
• The company's tax rate is 25%.
• The company is extremely profitable; so if any losses are incurred from the high-protein energy smoothie project they can be used to partially offset taxes paid on the company's other projects. (That is, assume that if there are any tax credits related to this project they can be used in the year they occur.)
• The project has a WACC = 10.0%.

What is the project's expected NPV and IRR? Round your answers to 2 decimal places. Do not round your intermediate calculations.

Answer 1

The IRR, or the internal rate of return, is the rate of return generated by the project.

The NPV, or the net present value is given as the present value (PV) of net inflows minus the initial investment of the project.

The book value of the equipment after 3 years will be nil because 100% depreciation is claimed as deduction in the first year.

Since the equipment is expected to be sold for $ 1,700,000 before taxes , the salvage value net of taxes is $1,700,000 - ($1,700,000×25%).

Salvage Value net of taxes = $1,275,000

The cash flows of the project is as follows

Particulars	year0	year1	year2	year3
Sales		2,100,000	7,900,000	3,200,000
Less costs		1,260,000	4,740,000	1,920,000
Less depreciation	4,800,000
Annual profit	(4,800,000)	8,40,000	3,160,000	1,280,000
Less tax@25%	1,200,000	210,000	790,000	320,000
Net income or loss	(3,600,000)	630,000	2,370,000	960,000
Add back depreciation	4,800,000
Cash flow after tax	1,200,000	630,000	2,370,000	960,000
Less initial investment	4,800,000
Less working capital	730,000
Add salvage Value net of taxes				1,275,000
Add working capital recovered				730,000
Cash flows	(4,330,000)	630,000	2,370,000	2,965,000

The NPV @10% is

Year	inflow/ outflow	discounting factor	present value
0	(4,330,000)	1.0000	(4,330,000)
1	630,000	0.9090909	572,727.28
2	2,370,000	0.8264462	1,958,677.68
3	2,965,000	0.7513148	2,227,648.38
	Sum NPV		429,053.34

At the IRR, the NPV is zero.

So we will need to find out the NPV at different rates and use interpolation to get the exact IRR.

The NPV @13% is

Year	cash flow	Df@13%	present value	Df@14%	present value
0	(4,330,000)	1.0000	(4,330,000)	1.0000	(4,330,000)
1	630,000	0.884955	557,522.12	0.877192	552,631.58
2	2,370,000	0.7831466	1,856,057.64	0.769467	1,823,638.04
3	2,965,000	0.6930501	2,054,893.73	0.6749715	2,001,290.55
	Sum NPV		138,473.49		47,560.17

IRR = 13% + (138473.49 ÷{138473.49 - 47560.17}) × 1%

= 14.523%