Blue Note Jazz Productions has decided to cash in on the country craze by starti

Question

Blue Note Jazz Productions has decided to cash in on the country craze by starting a subsidiary that will promote concerts by "Country Jazz" artists for the next three years. The country music boom is expected to subside by this time and the subsidiary will be folded. Blue Note expects that average ticket prices will be $35 and that ticket sales for the three years will be 300,000 tickets per year. Fixed cost each year are expected to be $3,000,000 and variable costs are expected to be 25% of sales. The subsidiary will need $4,000,000 in new equipment to start up and requires a $300,000 investment in working capital. The $4,000,000 in equipment will be depreciated straight-line over five years to a zero salvage value, but will be sold at the end of three years for an estimated $1,500,000.    The firm's marginal tax rate is 40%. What is the NPV of this new investment if the firm's required rate of return is 12%? What is the IRR? Should the project be accepted?

Explanation / Answer

Fixed cost investment for new equipement = FCinv = 4,000,000
and working capital investment = WCinv = 300,000
The initial outlay of the new equipment = FCinv + WCinv
=4,000,000 + 300,000
=4300,000

Depreciation of the equipment using SLM to zero salvage at the end of 5 years = 4000,000 / 5 = 800,000 per year

Sales per year are price of tickets * no of tickets sold
= 35*300,000
= 10500,000

out of which variable cost = 25% thus it is 0.25*10500,000 = 2625,000
and fixed cost given = 3000000
thus total cost = 5625,000

After tax opertaing cashflow = (sales-cost-depreciation)*(1-tax)+depreciation
= (10500,000-5625,000-800,000)*(1-0.4)+800,000
= 3245000

The boovalue of machine at the end of three years would be 4,000,000-(3*800,000) = 1600,000
Salvage given at the end of year three = 1500,000
and thus the terminal value cashflow = salvage+WCinv - Tax*(salvage-bookvalue)
=1500,000+300,000 - 0.4*(1500,000-1600,000)
= 1800,000 - (-40000)
= 1840000
(which will get added to final year cashflow and it will be 1840,000+3245,000 = 5085,000)

NPV of the new investment using 12% required rate of return is:

Years

Cashflows

0

-4300000

1

3245000

2

3245000

3

5085000

NPV at 12%

$4,288,944.75

IRR

64.799%

Yes the project should be accepted as the NPV is positive and IRR is greater than the required rate of return.

Years

Cashflows

0

-4300000

1

3245000

2

3245000

3

5085000

NPV at 12%

$4,288,944.75

IRR

64.799%

You can also calculate NPV by inserting respective cashflows in your financial calculator and by pressing CPT and then NPV at 12% and CPT I/Y for IRR

Related Questions

Navigate

• Browse (All)
• Browse B
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.