You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago for $1.42 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $1,520,000 on an aftertax basis. In four years, the land could be sold for $1,620,000 after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $127,000. An excerpt of the marketing report is as follows:
The zither industry will have a rapid expansion in the next four years. With the brand name recognition that PUTZ brings to bear, we feel that the company will be able to sell 4,000, 4,900, 5,500, and 4,400 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $670 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued.
PUTZ feels that fixed costs for the project will be $435,000 per year, and variable costs are 20 percent of sales. The equipment necessary for production will cost $3.7 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $410,000. Net working capital of $127,000 will be required immediately and will be recaptured at the end of the project. PUTZ has a 40 percent tax rate, and the required return on the project is 12 percent. Assume the company has other profitable projects.
What is the NPV of the project?
NPV = £397,892.25
The company should accept the new product line.
To calculate the NPV (Net Present Value) of the project, we need to determine the cash flows for each year and discount them to present value.
1. Calculate cash inflows:
Year 1: Number of units sold x selling price = 4,000 x $670 = $2,680,000
Year 2: 4,900 x $670 = $3,283,000
Year 3: 5,500 x $670 = $3,685,000
Year 4: 4,400 x $670 = $2,948,000
2. Calculate total revenue for each year:
Year 1: Cash inflows - Variable costs - Fixed costs = $2,680,000 - (0.2 x $2,680,000) - $435,000 = $1,704,000
Year 2: $1,899,000
Year 3: $2,119,000
Year 4: $1,757,000
3. Calculate depreciation expense using the MACRS schedule:
Year 1: 33.33% x $3,700,000 (equipment cost) = $1,230,110
Year 2: 44.45% x $3,700,000 = $1,644,665
Year 3: 14.81% x $3,700,000 = $547,170
Year 4: No depreciation since the project ends
4. Calculate net operating cash flow for each year:
Year 1: Total revenue - Depreciation expense = $1,704,000 - $1,230,110 = $473,890
Year 2: $1,899,000 - $1,644,665 = $254,335
Year 3: $2,119,000 - $547,170 = $1,571,830
Year 4: $1,757,000
5. Calculate the terminal cash flow:
Terminal cash inflow = Sale value of equipment + Net working capital recaptured = $410,000 + $127,000 = $537,000
6. Calculate discounted cash flows:
Year 1: $473,890 / (1 + 0.12) = $423,014.29
Year 2: $254,335 / (1 + 0.12)^2 = $193,098.43
Year 3: $1,571,830 / (1 + 0.12)^3 = $1,056,316.83
Year 4: $1,757,000 / (1 + 0.12)^4 = $991,280.16
Terminal cash flow: $537,000 / (1 + 0.12)^4 = $345,837.89
7. Calculate the NPV:
NPV = Sum of discounted cash flows - Initial investment
NPV = $423,014.29 + $193,098.43 + $1,056,316.83 + $991,280.16 + $345,837.89 - $3,700,000
NPV = -$700,452.40
The NPV of the project is approximately -$700,452.40. Since this value is negative, it indicates that the project is not financially viable and may result in a loss.