Suppose you have been hired as a financial consultant to Trader Joe\'s to evalua

Question

Suppose you have been hired as a financial consultant to Trader Joe's to evaluate introducing a new soda line. The cost of each new can of soda will be $0.81 and Trader Joe's will sell each can for $0.95. The project will last for seven (7) years. Trader Joe's will need to build a new manufacturing plant at a cost of $320,000,000.00. They will use land that is currently valued at 5.00 million dollars the following market data on Trader Joe's securities are current:

Debt: 175,000, 8.50% coupon bonds outstanding, 20 years to maturity, selling for 95,00% of par; the bonds have a $1000 par value each and make semiannual payments.

Common Stock: 22,000,000.00 shares outstanding, selling for $75.00 per share; the beta is 2.80

Market: 7.00% expected market risk premium; 1.00% risk-free rate.

Trader Joe's tax rate is 35.00%. The project requires $12.00 million in initial net working capital investment to get operational. The manufacturing plant has an 7-year tax life, and Trader Joe's uses straight line depreciation. At the end of the project (that is, the end of the year 7), the plant an equipment can be scrapped for $5,000,000.00. The company will incur $11,000,000.00 in annual fixed costs. Trader joe's project sale of 960.00 million cans of soda per year. Should trader joe's go ahead with this project (use both NPV and IRR rules)?

Explanation / Answer

Cost per can 0.81 S.P.per can 0.95 Life of project 7 Plant 3.2E+08 Land 5000000 No. Coupon Years to maturity Price Par Debt 175000 8.50% 20 95% 1000 (Bonds) Semi annual No. Price Beta Rm - Rf Rf Common stock 22000000 75 2.8 7% 1% Tax rate 35% Initial NWC 12000000 Salvage value 5000000 Annual FC 11000000 Annual Sales (Units) 9.6E+08 1) Initial cost - Plant 320000000 Land 5000000 Initial NWC 12000000 337000000 2) Annual Cash flow After tax (CFAT) Revanue (Units X SP. Per unit) 912000000 Operating Expenses (Units X Cost Per unit) 777600000 Fixed cost 11000000 Depreciation (320000000/7) 45714285.71 PBT 77685714.29 Less: Tax @ 35% 27190000 PAT 50495714.29 Depreciation 45714285.71 CFAT 96210000 3) WACC (Discount rate) (i) YTM of bond is the rate at which price of bond = PV of all future cash flows market value of bond= 1000 x 95% = 950 Semi annual Coupons = 1000 x 8.5% x 0.5 = 42.5 Redumption value = Par value 1000 Maturity (Years) 20 (Semi-annual) 40 Price = Coupon x PVAF(YTM, 40) + Redumption value x PVIF(YTM, 40) 950 = 42.5 x PVAF(YTM,40) + 1000 x PVIF(YTM,40) Using linear interpolation = YTM Price 4% 1049.48193 YTM 950 5% 871.306852 YTM- 4/ 5-4 = (950-1049.48)/(871.31-1049.48) YTM-4 = 0.5583 x 1 YTM = 4 + 0.5583 YTM = 4.5583 (%) For 6 months YTM = 9.116676 Annual (ii) Cost of equity - As per CAPM - Re = Rf + (Rm-Rf) x Beta Re = 1 + 7 x 2.8 Re = 20.60% Price No. Total Market value Weight Cost W x C Bonds 950 175000 166250000 0.09153476 5.9258395 0.542420272 Stock 75 22000000 1650000000 0.90846524 20.60 18.71438403 1816250000 19.25680431 Cost of debt (Post tax )= (9.1167 x (1-.35)) = 5.925839514 WACC = 19.25680431 4) Post tax salvage value - Salvage value x (1- tax) 5000000 x (1-0.35) = 3250000 5) NPV = Years 0 1 to 7 7 Initial investment -337000000 CFAT 96210000 Post tax salvage value 3250000 Recovery of NWC 12000000 Total cash flows -337000000 96210000 15250000 PV factors @ 19.25% 1 3.6793 0.291486085 PV of cash flows -337000000 353984611 4445162.801 NPV = 21429773.4 NPV is positive therefore project is viable. 6) IRR - Using linear interpolation Year Cash Flow PV Factors Present value 21% 22% 21% 22% 0 -337000000 1 1 -337000000 -337000000 1 96210000 0.826446 0.819672 79512396.69 78860655.7 2 96210000 0.683013 0.671862 65712724.54 64639881.8 3 96210000 0.564474 0.550707 54308036.81 52983509.6 4 96210000 0.466507 0.451399 44882675.05 43429106.3 5 96210000 0.385543 0.369999 37093119.88 35597628.1 6 96210000 0.318631 0.303278 30655470.97 29178383.7 7 111460000 0.263331 0.248589 29350901.6 27707683.9 4515325.548 -4603151 r= NPV = 21% 4515326 r 0 22% -4603151 r-21/22-21 (0-4515326)/(-4603151-4515326) r-21 = 0.4952 x 1 r = 21+ 0.4952 r = 21.495% Approx OR use IRR function In Excel For the project to be acceptable its rate of return or discount rate should not be more then IRR, Therefore Project is acceptable. Please provide feedback……... thanks in advance……… :-)

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