Question

Caspian Sea Drinks is considering the production of a diet drink. The expansion of the plant and the purchase of the equipment necessary to produce the diet drink will cost $25.00 million. The plant and equipment will be depreciated over 10 years to a book value of $1.00 million, and sold for that amount in year 10. Net working capital will increase by $1.19 million at the beginning of the project and will be recovered at the end. The new diet drink will produce revenues of $8.78 million per year and cost $2.04 million per year over the 10-year life of the project. Marketing estimates 10.00% of the buyers of the diet drink will be people who will switch from the regular drink. The marginal tax rate is 29.00%. The WACC is 10.00%. Find the IRR (internal rate of return).

Answer 1

Calculation of Internal rate of return (IRR) of project (in Millions)
	0	1	2	3	4	5	6	7	8	9	10
Cost of expansion	-25
Sale of plant and equipment											1
Increase in net working capital	-1.19
Recovery of net working capital											1.19
Operating Cash flow		$5.00	$5.00	$5.00	$5.00	$5.00	$5.00	$5.00	$5.00	$5.00	$5.00
Net Cash flows	-26.19	5.00286	5.00286	5.00286	5.00286	5.00286	5.00286	5.00286	5.00286	5.00286	7.19286
Internal rate of return (IRR)	14.47%
Working
Calculation of operating cash flows from project
Relevant revenue ($8.78 million x 90%)	$7.90
Less : Relevant cost ($2.04 million x 90%)	$1.84
Less : Depreciation	$2.40
Profit before tax	$3.67
Less : Tax @ 29%	$1.06
Add : Depreciation	$2.40
Operating Cash flows	$5.00
Depreciation per year = (Cost - ending book value) / useful life = ($25 million - $1 million) / 10 years = $2.4 million