MINI-CASE ●^ ●^ ●^ ●^ ●
Ecsy-Cola^23
Libby Flannery, the regional manager of Ecsy-Cola, the international soft drinks empire, was
reviewing her investment plans for Central Asia. She had contemplated launching Ecsy-Cola in
the ex-Soviet republic of Inglistan in 2019. This would involve a capital outlay of $20 million in
2018 to build a bottling plant and set up a distribution system there. Fixed costs (for manufactur-
ing, distribution, and marketing) would then be $3 million per year from 2018 onward. This would
be sufficient to make and sell 200 million liters per year—enough for every man, woman, and
child in Inglistan to drink four bottles per week! But there would be few savings from building
a smaller plant, and import tariffs and transport costs in the region would keep all production
within national borders.
The variable costs of production and distribution would be 12 cents per liter. Company policy
requires a rate of return of 25% in nominal dollar terms, after local taxes but before deducting any
costs of financing. The sales revenue is forecasted to be 35 cents per liter.(^23) We thank Anthony Neuberger for suggesting this topic.
300 Part Three Best Practices in Capital Budgeting
bre44380_ch11_279-301.indd 300 10/06/15 10:06 AM
The manufacture of bucolic acid is a competitive business. Demand is steadily expanding,
and new plants are constantly being opened. Expected cash flows from an investment in a new
plant are as follows:
0 1 2 3
- Initial investment 100
- Revenues 100 100 100
- Cash operating costs 50 50 50
- Tax depreciation 33.33 33.33 33.33
- Income pretax 16.67 16.67 16.67
- Tax at 40% 6.67 6.67 6.67
- Net income 10 10 10
- After-tax salvage 15
- Cash flow (7 + 8 + 4 – 1) – 100 +43.33 +43.33 +58.33
NPV at 20% = 0
Assumptions:- Tax depreciation is straight-line over three years.
- Pretax salvage value is 25 in year 3 and 50 if the asset is scrapped in year 2.
- Tax on salvage value is 40% of the difference between salvage value and depreciated investment.
- The cost of capital is 20%.
a. What is the value of a one-year-old plant? Of a two-year-old plant?
b. Suppose that the government now changes tax depreciation to allow a 100% writeoff in
year 1. How does this affect the value of existing one- and two-year-old plants? Existing
plants must continue using the original tax depreciation schedule.
c. Would it now make sense to scrap existing plants when they are two rather than three
years old?
d. How would your answers change if the corporate income tax were abolished entirely?