Question 1a

The firm should build the bakery and proceed with the project. Based on the analysis, we
have a positive NPV which tells us that we will earn more income than what can be gained
by earning the discount rate. We also have an IRR that exceeds the cost of capital.

Free cash flow can be forcasted with the following formula,

FCFt = Salest - Actual Cash Costst - Actual Taxes Paidt
- Capital Expenditurest - ΔNet Working Capitalt + After-tax Proceeds from Asset Disposalt

Each component of the formula can be calculated with given assumptions.

1). Sales
The bakery has a capacity of 100M packages of cookies a year, and is expected to produce at
70% of plant capacity for year 1, 75% for year 2, 80% for year 3, 90% for years 4 and 5, 85%
for year 6, 80% for year 7, 75% for year 8, and then 70% for years 9 and 10. In year 1,
nominal wholesale price is $2.05 per package. From year 2 to year 5, with a real price growth
of 1% and inflation of 2%, nominal price increases by 3.02% annually [(1 + 1%)(1 + 2%) -
1=3.02%]. From year 6 onwards, nominal price increases at the same rate as inflation. Annual
gross sales revenue can be obtained by multiplying each year’s production quantity and
nominal wholesale price per package. Because the project expects 6% loss on revenues, net
annual sales revenue is 94% of gross sales in each year.

2). Actual Cash Costs

Actual cash costs include costs of ingredients per package (i), labeling and packaging (ii),
labor (iii), selling and distribution (iv), general administration and fixed costs (v),
depreciation on plant (vi) and equipment (vii), as well as opportunity cost of land (viii). Costs
(i), (ii) and (v) grow with inflation. Cost (iii) grows at a nominal rate of 3.02%, which is
calculated by [(1+1%)(1+2%)-1]. Cost (iv) includes initial advertising of $10M, and then is
expected to grow by 5% of gross sales each year. Cost (vi) is $1M per year given its purchase
price, residual value and depreciation period [(30-15)/15]. Cost (vii) can be calculated in the
same way. The only difference is that new equipment will be bought at the end of year 5
when the old one is fully depreciated, and the nominal purchase price of the new equipment
takes into account the inflation effect over the five years [20,000(1+0.02)^5]. Therefore, the
annual nominal depreciation cost of the new equipment is higher than that of the old one in
nominal terms. Cost (viii) is the after-tax cost of land rental, which is assumed to be paid at
the beginning of each year, and should adjust for inflation. Summing up different categories
of costs provides actual cash costs in each year.

3). Actual Taxes Paid

This is the tax expense on operating income. Since the project has negative operating income
in year 1, tax credit is provided in the first year, which can be used to offset the entire tax
expense in year 2 and part of tax expense in year 3. Because depreciation reduces taxable
income but not cash flow, it should be added back to after-tax operating income.

1
4). Capital Expenditure
There are three capital expenditures, which are construction cost and two equipment
purchases. Purchase of equipemnt at the end of year 5 should adjust for inflation.

5). ΔNet Working Capital

Net working capital changes at the same rate of anticipated growth of gross sales in the next
period. NWC at the end of year 10 is 0 since the bakery is closed at that time, and no sales are
expected in year 11.

6). After-tax Proceeds from Asset Disposal

After-tax proceeds can be collected after the disposal of the plant and bakery equipment
(twice). Since tax applies to the difference between claimed salvage value and residual book
value, net salvage values on plant and equipment are calculated by subtracting tax expense
from or adding tax credit to salvage values. Total after-tax salvage values are after-tax
proceeds from asset disposal.
Free cash flow for each year can be obtained using above information. At a discount rate of
10.20% (discussed in Question 1b), cash flows are converted to their present values. NPV is
obtained by summing up these present values. Based on given assumptions, the NPV of the
bakery project is -75.14 million dollars, IRR is 11.74%.NPV is obtained by summing up these
present values. Based on given assumptions, the NPV of the bakery project is 75.14 million
dollars, IRR is 11.74%.

Question 1b
We obtained the discount rate by finding the required rate of return according to the CAPM
model, which reflects the risk associated with the project. CAPM model where Ri=Rf+β
i*E(MRP). In this case
project
rF E(MRP) beta COC
2.5% 7.0% 1.10 10.20%

Question 2

Question 3
The different NPV values are obtained by changing each variable by  10% while
holding others constant. It is clearly observed that output prices have the largest sensitivity to
value. 10% changes in output prices result in approximately 100% changes in NPV, whereas
changes in other variables have considerably less impact on projected NPV.
2
3