The market for Grindit Manufacturing Company (G) products is growing rapidly and

Question

The market for Grindit Manufacturing Company (G) products is growing rapidly and the company just completed a marketing study costing $100,000 to test introducing a new special purpose product (code name KICK). Excerpts from that study follow:

"... we feel G could sell additional KICK units of 3,500, 5,000, 4500, 2000 over the next four years at a premium price of $650 each; but due to the special nature of this product sales have only a four-year market life.

... Despite favorable market tests in selected regions introducing this product carries an above average risk, but if KICK is successful spin-offs of other new products, altough uncertain, might be huge... erosion of current product sales is certain and estimated to reduce annual earnings before taxes of approximately $155,000 during the new product four-year life..."

If this project is accepted, G has stated it would use an owned and fully depreciated plant it is currently planning to sell for $2,000,000 after taxes. This property is expected to be worth the same amount at the end of theproject. New production equipment will cost $3,900,000, be depreciated according to the three year MACRS IRS schedule (see Text Page 323), and have an after-tax salvage value of $400,000.

Incremental fixed costs will be $320,000 per year, and variable costs will be 10% of annual revenue.

The required net working capital will be 20% of incremental sales and 100% recovered at the end of the project.

G's tax rate is 35%.

G's management has asked you to use this information and the normal company hurdle rate of 15% to ...

A. Format the cash flows

B. Calculate the NPV, IRR, and non-discounted payback.

Make any and all recommendations you think are appropriate.

Explanation / Answer

It is problem on capital budgeting. Company is introducing a product KICK. Its essetial points are-

1. It will use a existing fully depreciated machine which now can be sold at $2,000,000.It will be sold after 4 years of project life at same price. So consider $2,000,000 as outflow at time 0 and $2,000,0000 as inflow in time 4. No depreciation will be charged as it is already depreciated.

2. A new equipment will be purchased at $3,900,000. It is outflow at time 0. Inflow is $400,000 after 4 years. It will be depreciated at MACRS 3 years rate as stated in tax guideline. Thisa depreciation will be deducted from net income for tax calculation. Then it will be added to get cash flow.

3. There will be incremental sale of 3,500,5,000, 4,500 and 2,000 units in four years . Selling price is $650. It is cash inflow.

4. Following cash outflows are observed-

    - profit of existing production lines will decrease by $155,000.

    - variable cost is 10% of incremental revenues of point 3.

    - fixed cost of $320,000 in each year.

    - Incremental working capital of 20% of sales. It will be recovred in full.

On the basis of above informations, cash flow calculations are made in the table below:

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NPV calculation:

Consider the cash flows from previous table. Ascertain present value of $1 cash flows using 15% required discounting rate. Multiply the two to get yearly present value of cash flows. Add them for period 0 to period 4 to get NPV. It is shown in the table below.

Comment: As NPV is negative, 15% required earning is not possible. So project is rejected.

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IRR is the maximum return from the project. It is ascertained by using a discounting rate which will make NPV zero. Use 10% discount rate and calculate NPV. It is positive. So interpolate to get IRR. It is 11.66% as shown below:

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Non discounted pay back is the required time for recovering initial investment of time zero. It is shown below:

Answer: Pay back period is 3.16 years.

Statement showing cash flows during the project life Time 0 Time 1 Time 2 Time 3 Time 4 1. Cost of Plant -2,000,000 2,000,000 2. New production equipment -3,900,000 400,000 3. 3 years MACRS rate 33.33% 44.45% 14.81% 7.41% 4. Depreciation on new production      equipement [3,900,000-400,000]x(3) 1166550 1555750 518350 259350 4a Working capital requirement 455000 650000 585000 260000 4b Additional working capital reqd. 455000 195000 -65000 -325000 4c. Working capital recovered 260000 5. Additional units sold 3,500 5,000 4,500 2,000 6. Sale price $650 $650 $650 $650 7. Total sale [5*6] $2,275,000 $3,250,000 $2,925,000 $1,300,000 8. Reduction in earnigs made now 155,000 155,000 155,000 155,000 9. Incremental fixed cost 320,000 320,000 320,000 320,000 10. Variable cost 10% of revenue at (7) 227500 325000 292500 130000 11. Total cost of the project 702,500 800,000 767,500 605,000 12. Net profit before tax [7-11-4] 405,950 894,250 1,639,150 435,650 13. Tax 35% on 12 142082.5 312987.5 573702.5 152477.5 14. Net profit after tax [12-13] 263,868 581,263 1,065,448 283,173 15. Add Depreciation 1166550 1555750 518350 259350 16. Less working capital required [4b] -455000 -195000 65000 325000 17. Add: Working capital recovered [4c] 260000 18. Salvage value of new equipment [2] 400,000 19. Sale value of old machine 2,000,000 20. Net cash flow [14 to 19] -5,900,000 975,418 1,942,013 1,648,798 3,527,523

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