Question

The Rodriguez Company is considering an average-risk investment in a mineral water spring project that has a cost of $170,000. The project will produce 1000 cases of mineral water per year indefinitely starting at year 1. The year-1 sales price is $138 per case, and the current cost per case is $105. The firm is taxed at a rate of 25%. Both prices and costs are expected to rise after year 1 at a rate of 6% per year due to inflation. The firm uses only equity, and it has a cost of capital of 15%. Assume that cash flows consist only of after-tax profits because the spring has an indefinite life and will not be depreciated.

1. What is the present value of future cash flows? What is the NPV
2. Suppose that the company had forgotten to include future inflation. What would they have incorrectly calculated as the project’s NPV?

Answer 1

(a)

Year 1 sales price= 138

less :cost per case= -105

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Contribution per case= 33

No of cases=. 1000

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Total operating profit = 33*1000= 33000

less: tax@25% -8250

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After-tax profits 24750

Inflation rate = 6%

Cost of capital= 15%

Costs and prices are grown at 6%, so Cash flows will also grown with 6%

So, present Value of future cash inflows = Cash flows for year 1/(Cost of capital - Inflation rate)

24750/(15%-6%)

$275000

Present value of cash outflow = 170000

NPV = present Value of future cash inflows - present Value of cash outflow

275000-170000

105000

So, NPV is $105,000

(b) if Inflation rate not considered

After tax profits= 24750

Cost of capital= 15%

Present value of Cash inflows on case of perpetuity Cash inflows/cost of capital

24750/15%

$165000

NPV = present Value of future cash inflows - present Value of cash outflow

165000-170000

-5000

So, project NPV calculated is -$5000