Capital Budgeting
Question 1
Hawaiian Coconut Milkshakes Inc. is considering the following project.
They would like to expand and add a pineapple branch. The firm has paid
$195,000 to a consultant in order to find out more about the available projects
and possibilities. The marketing department has done extensive consumer
research on the potential demand for the new shakes. The total costs for this
research has been $275,000. Based on this research, you are now considering
opening up a Pineapple Juice division in the firm.
The expected sales for this project are $1,600,000 per year for the
next 3 years. Accepting the project would mean that you could use a currently
owned empty storage unit. This storage unit consists of a 12,000 square feet
building, for which you paid $50,000 in 1985. This storage unit has been fully
depreciated and has a current market value of $60,000, which is expected to
remain stable over time regardless of its use. Accepting the project would also
mean that your current coconut shake sales are affected. In fact, you expect to
see your current total after-tax cash flows (not revenues!) from coconut shakes
(currently $1 million each year) increase by 14% immediately because of the
pineapple project and remains at this new level as long as the pineapple
project is in operations.
Manufacturing plant and equipment for this project (other than the
storage unit) will cost $900,000 and will be depreciated according to a
straight-line method over the life of the project. The market value of the
manufacturing plant and equipment at the end of the project (t = 3) is
$175,000. Variable costs are projected at 70% of sales. There are no fixed
costs associated with the project. Net working capital requirements are $25,000
at the start, and then respectively 12% and 18% of sales in t = 1, and t = 2.
At t = 3 the NWC investments will be recovered. The required rate of return on
this project is 18% and the corporate tax rate is 34%.
Calculate the NPV and IRR for this project and indicate whether you
should accept or reject the pineapple project.
[Hint: figure out for t = 0,1,2,3 what the cash flows from the project
are (i.e., cash flow from assets, using the cash flow identity: CF from Assets
= Operating CF – additions to NWC – Net Capital Spending, where Operating CF =
EBIT + Depreciation – Taxes)]
Question 2
Consider the following two mutually exclusive projects:
Cash Flows ($)
Project
C0
C1
C2
C3
A
-$100
+$60
+$60
+$60
B
-$100
—-
—-
+$208.35
a. Calculate the NPV of each project for discount rates of 0%, 10%, and
20% respectively.
b. What is approximately the IRR for each project individually?
c. Use the IRR method to determine which of the projects you should
accept (i.e., give the correct decision rule).
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