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 $28.00 million. The plant and equipment will be depreciated over 10 years to a book value of $2.00 million, and sold for that amount in year 10. Net working capital will increase by $1.30 million at the beginning of the project and will be recovered at the end. The new diet drink will produce revenues of $8.89 million per year and cost $1.77 million per year over the 10-year life of the project. Marketing estimates 11.00% of the buyers of the diet drink will be people who will switch from the regular drink. The marginal tax rate is 20.00%. The WACC is 15.00%. Find the NPV (net present value).

Answer 1

Assuming Straight line method of depreciation (equal amount each year)

Depreciation each year = (Cost - Salvage value) /no. of years = (28-2)/10 = $2.6 million

So, From year 1 - 10

Revenue = $.8.89 million

Cost =$ 1.77 million

Depreciation = $2.6 million

Profit Before Tax = $4.52 million

Tax (@20%) = $0.904 million

Proft after taax = $3.616 million

Free cash flow =$ 6.216 million (as depreciation is not an actual expense)

Since capital expenditures are generally not tax deductible, we have assumed no tax benefit on capital expenditure & as the plant and equipment shall be sold at the same price as the book value, there shall be no tax problem here either.

So , the project's NPV is (all figures in million dollars)

NPV = (-28 - 1.3) + 6.216/1.15+ 6.216/1.15² + ..... + 6.216/1.15⁹ + (6.216+1.3+2)/ 1.15¹⁰

(as increase in Working Capital shall be recoverd in the last year along with Salvage value)

NPV = -29.3 +5.405+4.700+4.087+3.554+3.0905+2.687+2.3368+2.0320+1.7669+2.3522

=  2.7124

So, the NPV of the project is $2.7124 million