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 $1.30 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 $1.40 million on an aftertax basis. In four years, the land could be sold for $1.50 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $115,000. 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 2,800, 3,700, 4,300, and 3,200 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $550 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 believes that fixed costs for the project will be $375,000 per year, and variable costs are 20 percent of sales. The equipment necessary for production will cost $2.50 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $350,000. Net working capital of $115,000 will be required immediately. PUTZ has a 40 percent tax rate, and the required return on the project is 12 percent.
What is the NPV of the project? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
To calculate the Net Present Value (NPV) of the project, we need to calculate the cash flows for each year and discount them to present value using the required return rate of 12 percent.
1. Calculate the annual cash flows:
- Sales revenue per year: 2,800 * $550 = $1,540,000
3,700 * $550 = $2,035,000
4,300 * $550 = $2,365,000
3,200 * $550 = $1,760,000
- Variable costs per year: 20% of sales revenue
Year 1: 20% * $1,540,000 = $308,000
Year 2: 20% * $2,035,000 = $407,000
Year 3: 20% * $2,365,000 = $473,000
Year 4: 20% * $1,760,000 = $352,000
- Fixed costs per year: $375,000
- Depreciation expense of equipment (MACRS depreciation):
Year 1: $2,500,000 / 3 = $833,333
Year 2: $2,500,000 / 3 = $833,333
Year 3: $2,500,000 / 3 = $833,333
Year 4: $2,500,000 * 0.00 (end of project) = $0
- Salvage value of equipment at the end of the project: $350,000
- Tax rate: 40%
2. Calculate the annual after-tax cash flows:
Year 1: (Sales revenue - Variable costs - Fixed costs - Depreciation) * (1 - Tax rate)
Year 1: ($1,540,000 - $308,000 - $375,000 - $833,333) * (1 - 0.40)
Year 1: $806,667
Year 2: ($2,035,000 - $407,000 - $375,000 - $833,333) * (1 - 0.40)
Year 2: $754,000
Year 3: ($2,365,000 - $473,000 - $375,000 - $833,333) * (1 - 0.40)
Year 3: $742,000
Year 4: ($1,760,000 - $352,000 - $375,000 - $0) * (1 - 0.40)
Year 4: $636,000
3. Calculate the present value of each cash flow:
PV of Year 1 cash flow: $806,667 / (1 + 0.12)^1 = $720,422.08
PV of Year 2 cash flow: $754,000 / (1 + 0.12)^2 = $601,896.82
PV of Year 3 cash flow: $742,000 / (1 + 0.12)^3 = $548,986.18
PV of Year 4 cash flow: $636,000 / (1 + 0.12)^4 = $448,957.97
PV of Salvage value: $350,000 / (1 + 0.12)^4 = $246,714.77
4. Calculate the NPV:
NPV = Sum of the present values - Initial investment
NPV = $720,422.08 + $601,896.82 + $548,986.18 + $448,957.97 + $246,714.77 - $2,500,000 (initial investment)
NPV = -$431,021.18
Therefore, the NPV of the project is -$431,021.18.