Question

Scooby Industries just received a patent on a new cancer treatment. The firm must now decide if it is worthwhile to start manufacturing the drug. To do this, the firm must buy new machines for a total of $860,000, which it will depreciate on a straight-line basis (to zero) over the next 7 years (Years 1 and 7 are complete years! Do not use the ½ year convention!). Scooby expects the machine to have no (economic) salvage value in 7 years, so it will be scrapped at that time. In each of the next 7 years, the firm expects to sell 11,000 units of this new treatment at a per unit price of $55. The variable cost of producing, marketing, and distributing this treatment will be $10 per unit, and the firm will have fixed costs (excluding depreciation) of $200,000 each year. The firm's tax rate is 35% (on both income and capital gains), and the discount rate is 10%. A. What is the incremental Net Income and cash flow in each of the next seven years? B. Calculate the NPV and the IRR for this project. Based on this information, should the company start manufacturing the drug? C. Calculate the NPV break-even point (in units) of this project.

Answer 1

Revenue-Variable Cost per year=11000*(55-10)=$495000

Hence, the NPV=$282861.32 and IRR=19.41%

As the NPV >0 , the company should start the project.

C.

9014 is the break even unit for this project.

Year	Initial Investment	Units	Revenue	VC	Revenue-Variable Cost	Fixed Cost	Gross Profit (Reveue-VC-FC)	Depreciation Expense	Tax (Gross Profit-Depreciation)*Tax rate	Net Income (Gross Profit-Depreciation-Tax)	Cash Flow (Gross Profit-Tax)	Present Value (Cash flow/1.1^year)
0	(860,000)	-	-	-	-	-	(860,000)	-	-	(860,000)	(860,000)	(860,000)
1	-	9,014	495,770	90,140	405,630	200,000	205,630	122,857	28,971	53,802	176,660	160,600
2	-	9,014	495,770	90,140	405,630	200,000	205,630	122,857	28,971	53,802	176,660	146,000
3	-	9,014	495,770	90,140	405,630	200,000	205,630	122,857	28,971	53,802	176,660	132,727
4	-	9,014	495,770	90,140	405,630	200,000	205,630	122,857	28,971	53,802	176,660	120,661
5	-	9,014	495,770	90,140	405,630	200,000	205,630	122,857	28,971	53,802	176,660	109,692
6	-	9,014	495,770	90,140	405,630	200,000	205,630	122,857	28,971	53,802	176,660	99,720
7	-	9,014	495,770	90,140	405,630	200,000	205,630	122,857	28,971	53,802	176,660	90,654
											Total(NPV)	52.43