McCormick & Company is considering a project that requires an initial investment of $24 million to...

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Finance

McCormick & Company is considering a project that requiresan initial investment of $24 million to build a new plant andpurchase equipment. The investment will be depreciated as amodified accelerated cost recovery system (MACRS) seven-year classasset. 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 andwill sell them for $420 each. There are annual fixed costs of$500,000. Unit sales are expected to be $150,000 each year for thenext six years, at which time the project will be abandoned. Atthat time, the plant and equipment is expected to be worth $8million (before tax) and the land is expected to be worth $5.4million (after tax).
To supplement the production process, the company will need topurchase $1 million worth of inventory. That inventory will bedepleted during the final year of the project. The company has $100million of debt outstanding with a yield to maturity of 8 percent,and has $150 million of equity outstanding with a beta of 0.9. Theexpected market return is 13 percent, and the risk-free rate is 5percent. The company's marginal tax rate is 40 percent.
Year Depreciation Rate
1 14.29%
2 24.49%
3 17.49%
4 12.49%
5 8.93%
6 8.92%
7 8.93%
8 4.46%
Questions
1. What will be the tax depreciation each year?
2. What will be the value of the plant and equipment for taxpurposes in year six? Will it be sold for a gain or a loss, andwhat will the tax effect be?
3. What is the weighted average cost of capital (WACC)?
4. What is the salvage cash flow of the new equipment? Includethe income tax effect.

5. What is the total operating cash flows, given the followingoperating cash flows:
Sales = 150,000 x $420 = $63,000,000
Costs = 150,000 x $130 + $500,000 = $20,000,000
6. Create an after-tax cash flow timeline.

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 atdate 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 discountrate.

9. Find the IRR.
10. Should the project be accepted? Discuss whether NPV or IRRcreates the best decision rule.

Answer & Explanation Solved by verified expert

3.7 Ratings (412 Votes)

0 1 2 3 4 5 6 1 Depreciation 1429 2449 1749 1249 893 892 Tax depreciation 3429600 5877600 4197600 2997600 2143200 2140800 20786400 2 Cost of the plant and equipment 24000000 Less Accumulated depreciation 20786400 Book value at EOY 6 3213600 Sale value 8000000 Gain 4786400 Tax at 40 1914560 After tax salvage value 80000001914560 6085440 3 After tax cost of debt 8140 480 Cost of equity per CAPM 509135 1220 WACC 1220150250480100150 1052 4 See Answer

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Transcribed Image Text

McCormick & Company is considering a project that requiresan initial investment of $24 million to build a new plant andpurchase equipment. The investment will be depreciated as amodified accelerated cost recovery system (MACRS) seven-year classasset. 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 andwill sell them for $420 each. There are annual fixed costs of$500,000. Unit sales are expected to be $150,000 each year for thenext six years, at which time the project will be abandoned. Atthat time, the plant and equipment is expected to be worth $8million (before tax) and the land is expected to be worth $5.4million (after tax).To supplement the production process, the company will need topurchase $1 million worth of inventory. That inventory will bedepleted during the final year of the project. The company has $100million of debt outstanding with a yield to maturity of 8 percent,and has $150 million of equity outstanding with a beta of 0.9. Theexpected market return is 13 percent, and the risk-free rate is 5percent. The company's marginal tax rate is 40 percent.YearDepreciation Rate114.29%224.49%317.49%412.49%58.93%68.92%78.93%84.46%Questions1. What will be the tax depreciation each year?2. What will be the value of the plant and equipment for taxpurposes in year six? Will it be sold for a gain or a loss, andwhat will the tax effect be?3. What is the weighted average cost of capital (WACC)?4. What is the salvage cash flow of the new equipment? Includethe income tax effect.5. What is the total operating cash flows, given the followingoperating cash flows:Sales = 150,000 x $420 = $63,000,000Costs = 150,000 x $130 + $500,000 = $20,000,0006. Create an after-tax cash flow timeline.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 atdate 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 discountrate.9. Find the IRR.10. Should the project be accepted? Discuss whether NPV or IRRcreates the best decision rule.

Year	Depreciation Rate
1	14.29%
2	24.49%
3	17.49%
4	12.49%
5	8.93%
6	8.92%
7	8.93%
8	4.46%