Problem 10-31 Calculating Project NPV(LO1j You have been hired as a consultant f

Question

Problem 10-31 Calculating Project NPV(LO1j You have been hired as a consultant for Pristine Urban-Ted, Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago for $1.47 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 $1.57 million on an aftertax basis. In four years, the land could be sold for S1.67 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $132,000. 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 4,500, 5,400, 6,000, and 4,900 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $720 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 $460,000 per year, and variable costs are 10 percent of sales. The equipment necessary for production will cost S4.20 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $435,000. Net working capital of $132,000 will be required immediately. PUTZ has a 40 percent tax rate, and the required return on the project is 14 percent. Refer to Table 107.

Explanation / Answer

To Solve this we need to consider few costs which are relevant and are known as Opportunity cost and here the present value of Land( $1570000) is such cost , however we need to ignore the cost paid to Marketing firm will not be considered as it is already paid and this project makes no difference to it. Below is the Solution and calculation of NPV of the Project

Working Note 1 - Use MACRS Depreciation Table for rates

Calculation of NPV is below -

Year 1 2 3 4 Total ($) A Revenue inflows ( Number of Units X Price of $720 )    3,240,000    3,888,000    4,320,000    3,528,000    14,976,000 Cost Fixed       460,000       460,000       460,000       460,000 Cost Variable (10 %of Sales)(10% of A)       324,000       388,800       432,000       352,800 B Costs outflows (Fixed +Variable )       784,000       848,800       892,000       812,800      3,337,600 C Before-tax net cash flows (A-B)    2,456,000    3,039,200    3,428,000    2,715,200    11,638,400 D Depreciation ( Working Note 1)    1,399,860    1,866,900       622,020       311,220      4,200,000 E Income before taxes (C-D)    1,056,140    1,172,300    2,805,980    2,403,980 T Taxes @ 40% of E       422,456       468,920    1,122,392       961,592 F After-tax net income (E-T)       633,684       703,380    1,683,588    1,442,388 D Depreciation (Add Back in F for G)    1,399,860    1,866,900       622,020       311,220 G After-tax cash flows (F+D)    2,033,544    2,570,280    2,305,608    1,753,608 After-tax salvage value ( Not to be considered in MACRS)                   -                     -                     -                     -   G After-tax total net cash flows    2,033,544    2,570,280    2,305,608    1,753,608 H Other Cash flow (Sale of Land after 4 years after Taxes)    1,670,000 I Final After-tax total net cash flows (G+S)    2,033,544    2,570,280    2,305,608    3,423,608    10,333,040 P Discount rate @ 14%                    0.8772                    0.7695                    0.675                    0.5921 PV Present value of cash flows ( I @P)    1783825    1977831    1556286    2027119      7345061

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