The Sun Devil Cookie Company is considering the construction ofa bakery to produce a new type of chocolate chip cookie that isfree of both cholesterol and saturated fat and has 2 calories percookie. The new cookies are to be called “Elf Bits.” The bakery isexpected to last for 25 years. Its initial cost is $85 million.This cost can be depreciated over 15 years using straight linedepreciation to a value of zero. After 15 years the bakery can berenovated. The cost of renovation will be $20 million in real termsand can be depreciated (again using straight line depreciation to avalue of zero) over the remaining 10 years of the bakery’s life.The salvage value of the equipment at the end of the project willbe $1 million in real terms (after-tax). The land the bakery isbuilt on could be rented out for $1.25 million a year in real termsfor 25 years with the rent collected at the beginning of eachyear.

The bakery will be able to produce 25 million packets of cookiesper year. The price of a packet of cookies is currently $2.75. Itis expected to grow at a rate of 5% per year in real terms for thefirst 2 years, then at 2% per year in real terms for 4 years, andfinally at 0% per year thereafter for the remainder of the bakery’slife. The firm expects to be able to sell all the packets of ElfBits that it can produce. The basic ingredients for a package ofcookies currently cost $0.75. These costs are expected to grow by1% in real terms through the lifetime of the project. The laborrequired to operate the bakery is expected to cost a total of $11million dollars in nominal terms during the first year and this isexpected to increase at 4% in real terms thereafter. The level ofworking capital for the project initially is $18 million and thisis expected to increase at 3% in real terms per year. At the end ofthe project, the working capital can be fully recovered.

The rate of inflation is expected to be 3% per year for thebakery’s life. The firm’s total tax rate including local taxes is36%. The firm expects to make substantial profits on its otheroperations so that it can offset any losses on the bakery for taxpurposes. Its opportunity cost of capital for projects of this typeis 11% in nominal terms.

Prepare an analysis of this capital budgeting problem, in whichyou compute the Net Present Value in both nominal and real terms.The value of the real and nominal NPVs should be the same. Presentyour answer in a brief memo outlining your valuation. Make sure youstate if the firm should build the bakery. You will probably wantto use a spreadsheet. An appendix to your memo should include acopy of your spreadsheet and the formulas you used in yourcomputations.