Question

McCormick & Company is considering a project that requires an initial investment of $24 million to build a new plant and purchase equipment. The investment will be depreciated as a modified accelerated cost recovery system (MACRS) seven-year class asset. The new plant will be built on some of the company's land, which has a current, after-tax market value of $4.3 million. The company will produce bulk units at a cost of $130 each and will sell them for $420 each. There are annual fixed costs of $500,000. Unit sales are expected to be $150,000 each year for the next six years, at which time the project will be abandoned. At that time, the plant and equipment is expected to be worth $8 million (before tax) and the land is expected to be worth $5.4 million (after tax). To supplement the production process, the company will need to purchase $1 million worth of inventory. That inventory will be depleted during the final year of the project. The company has $100 million of debt outstanding with a yield to maturity of 8 percent, and has $150 million of equity outstanding with a beta of 0.9. The expected market return is 13 percent, and the risk-free rate is 5 percent. The company's marginal tax rate is 40 percent. Should the project be accepted? questions: 6. Create an after-tax cash flow timeline. (what's the formula?) 7. What are the total expected cash flows at the end of year six? The $4.3 million is an opportunity cost and must be included at date zero as a cash outflow. If the project is accepted, however, the land can be sold in six years for $5.4 million. 8. Find the NPV using the after-tax WACC as the discount rate. 9. Find the IRR. 10. Should the project be accepted? Discuss whether NPV or IRR creates the best decision rule.

Answer 1

net cash from sale of land in year 6 = $5.4 million - ($5.4 million - $4.3 million) * (40%) = $4,960,000

accumulated depreciation on plant upto end of year 6 = $20,786,400

book value of plant at end of year 6 = $24 million - $20,786,400 = $3,213,600

sale price of plant at end of year 6 = $8 million

net cash from sale of plant = $8 million - ($8 million - $3,213,600)*(40%) = $6,085,440

net cash flow in each year = income after taxes + depreciation

f J8-G8+K8+L8+M8 N8 A B G H M N C Net Cash from Sale of plant and Equipment Flow Investment PV of Net Cash Flow Net Cash Investmentplant and land Income after Change in Inventory from Sale of land Income Net Cash eguipment Revenue Variable Cost Fixed Cost Depreciation before taxes Taxes taxes Year 0 ($4,300,000) ($24,000,000) ($1,000,000) ($29,300,000) $63,000,000 ($19,500,000) ($500,000) ($3,429,600) $39,570,400 ($15,828,160) $23,742,240 $27.171 840 1 'T/T'/7S $63,000,000 ($19,500,000) ($500,000) ($5,877,600) $37,122,400 ($14,848,960) $22,273,440 $28,151,040 4 $63,000,000 ($19,500,000) ($500,000) ($4,197,600) $38,802,400 ($15,520,960) $23,281,440 $63,000,000 ($19,500,000) ($500,000) ($2,997,600) $40,002,400 ($16,000,960) $24,001,440 $63,000,000 ($19,500,000) ($500,000) $27,479,040 5 $26.999.040 6 4 ($2,143,200) $40,856,800 ($16,342,720) $24,514,080 $26.657.280 7 5 $63,000,000 ($19,500,000) ($500,000) ($2,140,800) $40,859,200 ($16,343,680) $24,515,520 $1.000.000 $4.960.000 $6.085.440 $38.701.760 8 6

Present value of each net cash flow, discounted at the after-tax WACC discount rate, is the PV of each net cash flow. The sum of the PVs of each net cash flow is the NPV of the project

WACC = (cost of debt * weight of debt) + (cost of equity * weight of equity)

cost of debt = after tax cost of debt = YTM * (1 - tax rate) = 8% * (1 - 40%) = 4.8%

cost of equity = risk free rate + (beta * market risk premium) = 5% + (0.9 * (13% - 5%)) = 12.2%

weight of debt = $100 million / ($100 million + $150 million) = 0.40

weight of equity = $150 million / ($100 million + $150 million) = 0.60

WACC = (4.8% * 0.40) + (12.2% * 0.60) = 9.24%

NPV of the project is $99,112,261

IRR of the project is 76.22%

The project should be accepted as the NPV is positive, and the IRR is higher than the WACC

f 07 N7 / 1.0924 A7 G K N Net Cash from Sale of Investment Net Cash from Sale of land Net Cash Investment plant and land Income after Change in plant and Equipment Flow Income PV of Net Cash Flow Variable Cost Fixed Cost Depreciation before taxes Taxes Inventory ($1,000,000) equipment Revenue taxes 1 Year 0 ($4,300,000) ($24,000,000) ($29,300,000) ($29,300,000) $24,873,526 $63.000,000 ($19,500,000) ($500,000) ($500,000) ($500,0001 ($3,429,600) $39,570,400 ($15.828.160) $23.742.240 $27,171,840 2 $63,000,000 ($19,500,000) ($5,877,600) $37,122,400 ($14,848,960) $22,273,440 $28,151,040 $23,590,169 4 $63,000,000 ($4,197,600) $38,802,400 $27,479,040 $21,079,314 ($19,500,000) ($15,520,960) $23,281,440 5 $26,999,040 $18,959,268 $63,000,000 ($19,500,000) ($500,000) ($2,997,600) $40,002,400 ($16,000,960) $24,001,440 6 $26.657,280 $17,135,918 ($16,342,720) $24,514,080 $63.000.000 ($19.500.000) ($500,000) ($2,143,200) $40,856,800 7 8 $63.000.000 ($19,500,000) ($500.000) ($2,140,800) $40,859,200 ($16,343,680) $24,515,520 $1,000,000 $4.960,000 $6.085.440 $38.701.760 $22,774,066 6 NPV $99,112,261 76.22% 10 IRE