Posted: February 20th, 2017

What is the net present value (NPV) and internal rate of return (IRR) of the proposed investment?

Ted Flannery, the regional manager of Contact Manufacturing Ltd, the international soft drink empire, is reviewing his investment plans for Central Asia. He is contemplating to launch Melvita-water in the ex-Soviet republic of Inglistan. This will involve a capital outlay of $20 million to build a bottling plant and set up a distribution system there. Fixed costs (for manufacturing, distribution, and marketing) will then be $3 million per year from year 1 onward. This will be sufficient to make and sell 200 million litres per year – enough for every man, woman, and child in Inglistan to drink 4 bottles per week. But there will be a few savings from building smaller plant, and import tariffs and transport costs in region will keep all production within national borders. The variable costs of production and distribution will be 12₵ per litre. The sales revenue is forecasted to be 35₵ per litre. Bottling plants last almost forever, and all unit costs and revenues are expected to remain constant in nominal terms. Tax will be payable at a rate of 30%, and under the Inglistan corporate tax code, capital expenditures can be written off on a straight-line basis over 4 years. All these inputs were reasonably clear. But Mr. Flannery racks his brain trying to forecast sales. Melvita-water finds that the “1-2-4” rule works in most new markets. Sales typically double in the second year, double again in the third year, and after that remain roughly constant. Ted’s best guess was that, if he goes ahead immediately, initial sales in Inglistan would be 12.5 million litres in year 1, ramping up to 50 million in year 3 and onward. Contact Manufacturing Ltd currently has 1,600,000 shares outstanding. The current share price is $3. Last year’s earnings was $2,000,000. The company policy has just paid out $300,000 in dividends, and it intends to continue this 15% dividend payout from earnings in the future. Contact Manufacturing Ltd spent $600,000 on share repurchase last year. It is the 3 company’s intention to increase the amount spent on share repurchases at the same growth rate as the amount spent on dividends. Projected earnings growth is 2% per year. Using the inputs suggested in the proposed investment, design an Excel financial model that can help to evaluate the proposed investment. The model should enable Contact Manufacturing Ltd to consider the project and forecast the net cash flows, perhaps in various ways, and should assess the risks of the proposed investment. (10 marks) Answer the following questions using your Excel financial model: a. (5 marks) Suppose that Contact Manufacturing Ltd is financed by 80% equity and 20% debt. The interest rate on debt is 10%. What is Contact Manufacturing Ltd’s WACC? (Hint: Use the Gordon model for the total equity payout to calculate cost of equity.) b. (5 marks) What is the net present value (NPV) and internal rate of return (IRR) of the proposed investment? Should Contact Manufacturing Ltd accept the proposed investment based on NPV? How about IRR? Do both NPV and IRR lead to the same decision? c. (5 marks) Draw a sensitivity graph and explain the sensitivity of the NPV to revenues per litre and variable costs per litre? 4 Question 2 One of Contact Manufacturing Ltd’s main competitor, Torres Coffee Roaster is considering replacing one of its existing machine. Torres bought the machine 5 years ago for $90,000. It is being depreciated on straight-line basis over a 15-year life. The machine could be sold today for $30,000. The new, highly efficient machine costs $95,000. The new machine’s depreciable life is 10 years with a salvage value of $14,000. The new machine will be depreciated to zero over 10 years via straight line method. Last year, Torres’s current coffee roasting machine accounted for annual sale revenues of $50,000 and has annual costs of $25,000. The new machine will increase the sale revenues to $65,000 per year. The new machine will also increase operating costs by $3,000 per year. The corporate tax rate is 40%. The additional savings and costs are forecasted to increase by inflation rate of 3% each year. Using the inputs suggested in the proposed investment, design an Excel financial model that can help to evaluate the replacement project. The model should enable Torres Coffee Roaster to consider the replacement project and forecast the net cash flows, perhaps in various ways. (10 marks) Answer the following questions using your Excel financial model: a. (5 marks) If the WACC is 12% per annum, should Torres Coffee Roaster replace the old machine with the new, highly efficient machine? Explain your answer. 5 b. (10 marks) The NPV estimate assumes that economic conditions will be “average.” However, the CFO of Torres Coffee Roaster realizes that conditions could be better or worse, so he plans to performs a scenario analysis and obtain the following results.