Capital budgeting. Felix, an exclusive Estonian wine producer, is considering th

Question

Capital budgeting.

Felix, an exclusive Estonian wine producer, is considering the purchase of 10,000 French oak barrels at a cost of 900 eur each. The investment into barrels is considered a capital expense and would be depreciated straight line over 5 years. After 4 years, the barrels will be useless for making fine wine, but they expect to be able to sell them for 3 million eur to Gallo. The increase in the quality of its sweet apple line of wines due to the use of the new French oak barrels is expected to increase revenue by 7 million eur (only) in years 3 and 4. The barrels would have no influence on COGS, SG&A, other operating expenses. The additional working capital investment is 10% of the additional sales revenues and is fully recovered when the project ends (in four years). The tax rate is 40% (profits are taxed), and the required return is 12%.

a) Construct the capital budget

b) Evaluate the project on the basis of NPV and MIRR.

Explanation / Answer

Solution:

a.

Since the book value of the barrels is $1.8 million after 5 years, the after-tax cash flow from selling the barrels in year 5 is = sale price – × (sale price – book value) = $3 million – 0.40($3 million – 1.8 million) = $2.52 million

b. NPV = -9,700,000 + 720,000/1.12 + 720,000/1.12^2 + 4,920,000/1.12^3 + 8,140,000/1.12^4

NPV = $191,912.71

NPV = 0

-9,700,000 + 720,000/(1 + IRR) + 720,000/(1 + IRR)^2 + 4,920,000/(1 + IRR)^3 + 8,140,000/(1 + IRR)^4 = 0

IRR = 12.66%

1 2 3 4 Sales 0 0 7,000,000 7,000,000 Less: cost of goods sold 0 0 0 0 Less: Selling, general & adm. Costs 0 0 0 0 EBITDA 0 0 7,000,000 7,000,000 Less: Depreciation 1,800,000 1,800,000 1,800,000 1,800,000 EBIT -1,800,000 -1,800,000 5,200,000 5,200,000 Less: tax -720,000 -720,000 2080000 2080000 Net Income -1,080,000 -1,080,000 3,120,000 3,120,000

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