The Rodriguez Company is considering an average-risk investment in a mineral wat

Question

The Rodriguez Company is considering an average-risk investment in a mineral water spring project that has a cost of $150,000. The project will produce 750 cases of mineral water per year indefinitely. The current sales price is $150 per case, and the current cost per case is $110. The firm is taxed at a rate of 39%. Both prices and costs are expected to rise at a rate of 6% per year. The firm uses only equity, and it has a cost of capital of 16%. Assume that cash flows consist only of after-tax profits, since the spring has an indefinite life and will not be depreciated.

What is the NPV of the project? Do not round intermediate steps. Round your answer to the nearest hundred dollars. (Hint: The project is a growing perpetuity, so you must use the constant growth formula to find its NPV.)
$   ________   

Should the firm accept the project?
_________________

Suppose that total costs consisted of a fixed cost of $11,000 per year plus variable costs of $85 per unit, and suppose that only the variable costs were expected to increase with inflation. Would this make the project better or worse? Continue with the assumption that the sales price will rise with inflation.
This will make the project _________________ .

Explanation / Answer

Net cash flow every year = income - expenses = number of cases*(revenue per case - cost per case)

=750*(150-110) = $30,000

Now tax = 39% and after tax flow = (1-tax rate)*$30,000 = $18,300

Now this will grow at the rate of 6%.

Now, the present value of this will be = initial cash flow/(cost of capital - growth rate)

= 18,300/(16% - 6%)

= 18300/10% = $183,000

NPV = present value of inflows - initial outlay

= 183,000 - 150,000 = $33,000

As the NPV is positive, the project should be accepted.

Now, if there is a variable cost of $85, then margin contribution per case will be = 150 - 85 = $65.

Total margin = 65*750 cases = $48,750. Inflow = contribution margin - fixed cost = 48,750 - 11,000 = $37,750.

after tax inflow = (1-39%)*37750 = $23,027.50

PV of this = 23,027.50/(16% - 6%) = $230,275

NPV = 230,275 - 150,000

= $80,275

As NPV has increases, the project has become better.

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