Capital Budgeting

Question 1

Hawaiian Coconut Milkshakes Inc. is considering the following project. They would liketo expand and add a pineapple branch. The firm has paid $195,000 to a consultant inorder to find out more about the available projects and possibilities. The marketingdepartment has done extensive consumer research on the potential demand for thenew 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 storageunit. 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 marketvalue 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 areaffected. In fact, you expect to see your current total after-tax cash flows (notrevenues!) 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 asthe pineapple project is in operations.

Manufacturing plant and equipment for this project (other than the storage unit) willcost $900,000 and will be depreciated according to a straight-line method over the lifeof the project. The market value of the manufacturing plant and equipment at the endof the project (t = 3) is $175,000. Variable costs are projected at 70% of sales. There areno fixed costs associated with the project. Net working capital requirements are $25,000at the start, and then respectively 12% and 18% of sales in t = 1, and t = 2. At t = 3 theNWC 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 orreject the pineapple project.

[Hint: figure out for t = 0,1,2,3 what the cash flows from the project are (i.e., cash flowfrom assets, using the cash flow identity: CF from Assets = Operating CF - additions toNWC - Net Capital Spending, where Operating CF = EBIT + Depreciation - Taxes)]

Question 2

Consider the following two mutually exclusive projects:

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., givethe correct decision rule).