Tatum Inc. is considering expanding into the sports drink business with a new pr

Question

Tatum Inc. is considering expanding into the sports drink business with a new product. Assume that you were recently hired as assistant to the director of capital budgeting and you must evaluate the new project.

The sports drink would be produced in an unused building adjacent to Tatum’s Texas plant; Tatum owns the building, which is fully depreciated.  The required equipment would cost $850,000, plus an additional $150,000 for shipping and installation.  In addition, inventories would increase by $75,000, while accounts payable would increase by $25,000.  All of these costs would be incurred today.  The equipment will be depreciated by the straight-line method over the life of the project.

The project is expected to operate for 10 years, at which time it will be terminated.  The cash inflows are assumed to begin one year after the project is undertaken and to continue until the end of the tenth year.  At the end of the project’s life, the equipment is expected to have a salvage value of $150,000.

Unit sales are expected to total 200,000 units per year, and the expected sales price is $5.00 per unit.  Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales.  Tatum’s tax rate is 40%, and its WACC is 12%. Tentatively, the sports drink project is assumed to be of equal risk to Tatum’s other assets.  You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected.

Required:

Using net present value recommend whether or not Tatum should purchase the new equipment.

Determine the payback period for this project.

Determine the internal rate of return for the purchase of the equipment.

Explanation / Answer

INITIAL COST: Cost of equipment $      8,50,000 Shipping and installation $      1,50,000 Total cost of equipment $    10,00,000 Increase in NWC = 75000-25000 = $          50,000 Initial cost of the project $    10,50,000 ANNUAL AFTER TAX CASH FLOWS: Annual sales = 200000*5 = $    10,00,000 Cash operating cost = 1000000*60% = $      6,00,000 Depreciation = (1000000-150000)/10 = $          85,000 NOI $      3,15,000 Tax at 40% $      1,26,000 NOPAT $      1,89,000 Add: Depreciation $          85,000 OCF $      2,74,000 TERMINAL NON OPERATING AFTER TAX CASH FLOW: After tax sale value of equipment $      1,50,000 Recovery of NWC $          50,000 $      2,00,000 NPV: PV of Annual OCF = 274000*(1.12^10-1)/(0.12*1.12^10) = $    15,48,161 PV of terminal cash flow = 200000/1.12^10 = $          64,395 PV of cash inflows $    16,12,556 Less: Initial investment $    10,50,000 NPV $      5,62,556 As the NPV is positive, the new investment can be purchased. PAYBACK PERIOD: Payback periiod = Initial investment/Annual OCF = 1050000/274000 = 3.83 Years IRR: IRR is that discount rate for which NPV is 0. Hence, 274000*PVIFA(r,10)+200000*PVIF(r,10)-1050000 = 0 The value of r should be found out by trial and error such that NPV = 0. Using r = 23% The NPV = 274000*3.7993+200000*0.1262-1050000 = $          16,248 Using r = 24% The NPV = 274000*3.6819+200000*0.1164-1050000 = $        -17,879 The IRR lies between 23% and 24% The exact value can be found out by simple interpolation as below: IRR = 23+17879/(16248+17879) = 23.52 %

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