Gilmore Golf, Inc is considering producing and selling a new line of golf clubs.

Question

Gilmore Golf, Inc is considering producing and selling a new line of golf clubs. The clubs will sell for $1000 per set and have a variable cost of $450 per set. The company has spent $250,000 for a marketing study that determined the company will sell 4,000 sets per year for 22 years. The marketing study also determined that the company will lose sales of 1,500 sets per year of its high-priced clubs, which currently sell for $1500 per set and have variable costs of $750. The fixed costs each year will be $200,000. The project will require a net working capital balance equal to 8% of sales, to be fully recouped at the end of the project. This net working capital must be invested immediately. The plant and equipment required will cost $3,800,000 and will be depreciated on a straight-line basis to zero over the lifetime of the project. The company estimates it will be able to sell the plant and equipment in twenty years for $150,000. The tax rate is 40% and the required return on the project is 14%.

(7 points) Find the project’s NPV.

Find the project’s Profitability Index.

Find the project’s IRR.

How much does the NPV change if you change the demand for the new clubs by 1%?

(3 points) Should they pursue the project? Why or why not?

Explanation / Answer

Years Years Years Years Years Years Years Years Years Years Years Years Years Years Years Years Years Years Years Years Years 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 No. of sets sold 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 Revenue for the sets 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 4000000 ( 4000 * 1000 ) variable cost 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 1800000 ( 450* 4000 ) Contribution 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 2200000 Less: - Loss on contribution on sale of other product ( 1500*( 1500 - 750 ) 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 1125000 Net contribution 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 1075000 ( 2200000 - 1125000 ) Less : - Fixed cost 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 200000 Net operating profit before tax 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 875000 Less: - Depreciation 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 Add: - cash flow from sale of plant 150000 EBT 692500 692500 692500 692500 692500 692500 692500 692500 692500 692500 692500 692500 692500 692500 692500 692500 692500 692500 692500 842500 Less : - tax @ 40% 277000 277000 277000 277000 277000 277000 277000 277000 277000 277000 277000 277000 277000 277000 277000 277000 277000 277000 277000 337000 EAT 415500 415500 415500 415500 415500 415500 415500 415500 415500 415500 415500 415500 415500 415500 415500 415500 415500 415500 415500 505500 Add: - depreciation 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 182500 Less : - Working capital required - 8% of sales ( 8% * 4000000 ) 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 320000 CFAT 278000 278000 278000 278000 278000 278000 278000 278000 278000 278000 278000 278000 278000 278000 278000 278000 278000 278000 278000 368000 Discount rate - 14% Discount factor at 14% 0.877192982 0.769467528 0.674971516 0.592080277 0.519368664 0.455586548 0.399637323 0.35055905 0.30750794 0.26974381 0.23661738 0.2075591 0.1820694 0.15971 0.1400965 0.1228917 0.1077997 0.0945611 0.0829484 0.0727617 Present value of cash inflows 243859.6491 213911.9729 187642.0815 164598.3171 144384.4887 126653.0603 111099.1757 97455.4172 85487.2081 74988.779 65779.6307 57701.4305 50615.29 44399.377 38946.822 34163.879 29968.315 26287.996 23059.645 26776.314 Total cash flow at present value 1847779 Cash outflow at present value 3800000 Net present value -1952221 If NPV of the project is positive it should be considered for acceptence Profitability Index = PV of cash inflows / PV of cash outflows ( 1879577 / 3800000 ) 0.4863 Higher the PI the better the project If PI of the project is more than 1 it should be considered for acceptence IRR 4.050% By interpolation We get discount rate of 4.05%, where Present values of cash inflows is equal to present value of cash outflows On changing the demnad of new club On increasing the demand of producty by 1% ie 4040 NPV = -1885990 On decreasing the demand by 1 % ie 3960 NPV = -2018452 NPV at 4000 Units = -1952221 Ans : - the project should not be pursued as the NPV and PI of the project is negative at the give cost of capital It should be pursued only id cost of capital is less than IRR Note : - Since marketting cost has already been incured , it would not form part of future evaluation calculation of depreciation Depreciation = cost of asset - salvage / life of asset Cost of asset 3,800,000.00 Less : - salvage value 150000 Life time 20 years Depreciation = 182500

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