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 $25,000 at the start, and then respectively 12% and 18% of sales in t = 1, and t = 2. At t = 3 the NWC investments will be recovered. The required rate of return on this project is 18% and the corporate tax rate is 34%.
Calculate the NPV and IRR for this project and indicate whether you should accept or reject the pineapple project.
[Hint: figure out for t = 0,1,2,3 what the cash flows from the project are (i.e., cash flow from assets, using the cash flow identity: CF from Assets = Operating CF – additions to NWC – Net Capital Spending, where Operating CF = EBIT + Depreciation – Taxes)]
Consider the following two mutually exclusive projects:
Cash Flows ($)
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).