Question

Quantitative Problem: 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 million today (t = 0) to purchase additional equipment. For tax purposes the equipment will be depreciated on a straight-line basis over 5 years. Thus, the firm's annual depreciation expense is $4,000,000/5 = $800,000. 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 $1,200,000 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 $2,200,000 2 7,750,000 3 3,500,000 The project's annual operating costs (excluding depreciation) are expected to be 60% of sales. The company's tax rate is 40%. 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. NPV $ IRR %

Should the firm accept the project? SSC is considering another project: the introduction of a "weight loss" smoothie.

The project would require a $3.1 million investment outlay today (t = 0). The after-tax cash flows would depend on whether the "weight loss" smoothie is well received by consumers. There is a 40% chance that demand will be good, in which case the project will produce after-tax cash flows of $1.9 million at the end of each of the next 3 years. There is a 60% chance that demand will be poor, in which case the after-tax cash flows will be $0.5 million for 3 years. The project is riskier than the firm's other projects, so it has a WACC of 11%. The firm will know if the project is successful after receiving the cash flows the first year, and after receiving the first year's cash flows it will have the option to abandon the project. If the firm decides to abandon the project the company will not receive any cash flows after t = 1, but it will be able to sell the assets related to the project for $2.25 million after taxes at t = 1. Assuming the company has an option to abandon the project, what is the expected NPV of the project today? Round your answer to 2 decimal places. Do not round your intermediate calculations. Use the values in "millions of dollars" to ascertain the answer. $ millions of dollars

Answer 1

Solution:

1.a)Calculation of Net Present Value(NPV)

After Tax salvage value of Equipment=(Salvage value-book value)(1-tax rate)

Book value at the end of year 3=4,000,000-(800000*3)

=1600,000

Since book value is higher than the salvage value hence loss from the sale would result in tax saving as fllows;

=(1600,000-1200,000)*.40

=$160,000

Initial Cash outlay=Cost of Equipment+Net Working Capital

=4,000,000+730,000

=$4730,000

Statement showing after tax Net cash flows and its Present value

Year	1($)	2($)	3($)
Annual Sales	2,200,000	7,750,000	3,500,000
Less:Annual Operating Cost @60% of Sales	1320,000	4650,000	2100,000
Less:Annual Depreciation	800,000	800,000	800,000
EBT	80,000	2300,000	600,000
Less: Tax @40%	32,000	920,000	240,000
EAT	48,000	1380,000	360,000
Add:Depreciation	800,000	800,000	800,000
Annual after Tax cash inflows	848,000	2180,000	1160,000
After Tax salvage value of Equipment	-	-	1200,000
Tax saving due sale of equipment	-	-	160,000
Reversal of Working capital	-	-	730,000
Total After tax cash inflows(a)	848,000	2180,000	3250,000
Present value factor @10%(b)	.909	.826	.751
Present value(a*b)	770,832	1800,680	244,0750

Net Present value=Sum of Present value of cash inflows-Initial cash outlay

=$(770,832+1800,680+244,0750)-$4730,000

=$282,262

Thus,NPV of project is $282,262

b)Calculation of IRR

IRR is the rate at which NPV of the project is zero.Since the NPV at the rate of 10% is higher than zero,hence IRR would be higher than 10%.Lets calculate the NPV at discounting rate of 20%

Year	Cash Inflows	Present Value factor@20%	Presen value($)
1	848,000	.833	706,384
2	2180,000	.694	1512,920
3	3250,000	.579	1881,750
Total Present Value of Cash inflows	4101,054
Less:Initial Cash outlay	4730,000
Net present value	$628,946

Now IRR is;

=Lower Discounting Rate+[NPV at lower rate/Present value at(Lower rate-Higher Rate)]*differece of lower rate and higher rate

=10%+$282,262/($5012,262-$4101,054)*20-10

=10%+($282,262/911208)*10

=10%+3.10

=13.10%

Thus IRR is 13.10%