A business opportunity has presented itself to you and one of your classmates. Your opportunity is to enter the fast growing craft beer industry. Your projected sales in the first year is 8300 kegs. Your projected growth rate is 5 percent. Entering the business will require $35,000 of net working capital. Total fixed costs are $95,000. Variable production costs are $36 per keg and keg sales are priced at $57 each. The equipment to begin production is $175,000. The equipment will be depreciated using straight line depreciation over a five year life and has no salvage value. The tax rate is 35 percent and the required return is 25 percent. What is the NPV of the project and should you pursue the project?

Question

A business opportunity has presented itself to you and one of your classmates. Your opportunity is to enter the fast growing craft beer industry. Your projected sales in the first year is 8300 kegs. Your projected growth rate is 5 percent. Entering the business will require $35,000 of net working capital. Total fixed costs are $95,000. Variable production costs are $36 per keg and keg sales are priced at $57 each. The equipment to begin production is $175,000. The equipment will be depreciated using straight line depreciation over a five year life and has no salvage value. The tax rate is 35 percent and the required return is 25 percent. What is the NPV of the project and should you pursue the project?

Answer 1

To calculate the Net Present Value (NPV) of the project and determine whether you should pursue it, we need to follow these steps:

Step 1: Calculate the cash flows for each year.
Step 2: Discount the cash flows to their present value.
Step 3: Calculate the NPV by subtracting the initial investment from the discounted cash flows.
Step 4: Analyze the NPV to determine whether you should pursue the project.

Let's go through each step in detail:

Step 1: Calculate the cash flows for each year.

In this case, we have the following cash flows:

Year 0 (Initial Investment):
- Equipment cost: $175,000
- Net working capital: $35,000
Total cash outflow: $210,000

Year 1:
- Keg sales: 8,300 kegs x $57/keg = $473,100
- Variable production costs: 8,300 kegs x $36/keg = $298,800
- Fixed costs: $95,000
Net cash flow: $473,100 - $298,800 - $95,000 = $79,300

Year 2 (and subsequent years):
- Projected sales growth rate: 5%
- Keg sales: Year 1 sales x (1 + growth rate) = $473,100 x (1 + 0.05) = $496,755
- Variable production costs: Year 2 sales x variable cost per keg = $496,755 x $36/keg = $178,794
- Fixed costs: $95,000
Net cash flow: $496,755 - $178,794 - $95,000 = $222,961

Step 2: Discount the cash flows to their present value.

To calculate the present value of the cash flows, we will use the required return rate of 25%. We will discount the cash flows using the formula:

Present Value = Cash Flow / (1 + Required Return Rate) ^ Year

Year 0:
Present Value = $210,000 / (1 + 0.25)^0 = $210,000

Year 1:
Present Value = $79,300 / (1 + 0.25)^1 = $63,440

Year 2 (and subsequent years):
Present Value = $222,961 / (1 + 0.25)^2 = $148,136

Step 3: Calculate the NPV by subtracting the initial investment from the discounted cash flows.

NPV = Sum of Present Values - Initial Investment
NPV = $63,440 + $148,136 - $210,000 = $1,576

Step 4: Analyze the NPV to determine whether you should pursue the project.

If the NPV is positive, it indicates that the project is expected to generate more value than the initial investment and is financially favorable. In this case, the NPV is $1,576, which means the project has a positive NPV.

Therefore, based on the given assumptions and calculations, you should pursue the project as it is expected to generate positive returns and create value for your business.