Your company is trying to determine if it should embark on a 5-year project to d

Question

Your company is trying to determine if it should embark on a 5-year project to develop and sell a new product.

-To begin the process, you need to purchase new equipment immediately for $3,500,000

-You expect first year sales to be $2,000,000. You expect year 2, 3, 4 and 5 sales will follow the pattern set out below;

Year                      sales

1                      $2,000,000

2                      +100%

3                       -25%

4                      -50%

5                     -50%

-Sales commissions will be 5% of revenue

-Marketing expense will hold constant at 10% of revenue in each year.

-Depreciation will be 20% per year for the life of the project.

-Variable expenses are 40% of revenue

-Tax rate is 30%

The cost of capital is 11%. The factors are:

Year                    Factor

1                      .901

2    .812

3 .731

4                    .659

5                .593

Explanation / Answer

Year 1 2 3 4 5 Sales a $2,000,000.00 +100% -25% -50% -50% Actual Sales b $2,000,000.00 $4,000,000.00 $3,000,000.00 $1,500,000.00 $750,000.00 Sales Commissions c = 5%*b $100,000.00 $200,000.00 $150,000.00 $75,000.00 $37,500.00 Marketing Expenses d = 10%*b $200,000.00 $400,000.00 $300,000.00 $150,000.00 $75,000.00 Depreciation (20% * $3.5m) e $700,000.00 $700,000.00 $700,000.00 $700,000.00 $700,000.00 Variable Expenses f = 40% * b $800,000.00 $1,600,000.00 $1,200,000.00 $600,000.00 $300,000.00 Profit before Tax and Depreciation g = b-c-d-f $900,000.00 $1,800,000.00 $1,350,000.00 $675,000.00 $337,500.00 Taxes at 30% h = g*30% $270,000.00 $540,000.00 $405,000.00 $202,500.00 $101,250.00 i = g - h $630,000.00 $1,260,000.00 $945,000.00 $472,500.00 $236,250.00 Depreciation Tax Shield j = e*.3 $210,000.00 $210,000.00 $210,000.00 $210,000.00 $210,000.00 Cashflow from operations k=i+j $840,000.00 $1,470,000.00 $1,155,000.00 $682,500.00 $446,250.00 Discount factor at 11% l 0.901 0.812 0.731 0.659 0.593 Present Value at 11% m = k*l $756,840.00 $1,193,640.00 $844,305.00 $449,767.50 $264,626.25 Total Present Value of Inflow = $3,509,178.75 Initial Outflow = $3,500,000 Net Present Value = 3509178.75 - $3,500,000 = $9,178.75 Sales Calculations - Sales Year 1 $2,000,000.00 Given Year 2 $4,000,000.00 Year 1 * (1 + 1) Year 3 $3,000,000.00 Year 2 * (1 - 0.25) Year 4 $1,500,000.00 Year 3 * (1 - 0.50) Year 5 $750,000.00 Year 4 * (1 - 0.50)

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