Question

You have been hired tas a consultatnt for Pristne Urban-Tech Zither, Inc (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land 3 years ago for $1.8 million in anticipation of using it as a toxic waste dump site but has reently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $2.1 million on an aftertax basis. The company also hired a marketing firm to analyse the zither market, at a cost of $275,000. An excerpt of the marketing report is as follows: The zither industry will have a rapid expansion in the next 4 years. With the brand name recognition that PUTZ brings to bear, we feel that the company will be able to sell 18,400, 26,100, 29,300, and 19,400 units each yearfor the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we eel that a premium price of $175 can be charged for each zither. Since zithers appear to be a fad, we geel at the end of the 4 year period, sales should be discontinued. Putz feels that fixed costs for the project will be $725,000 per year, and variable costs are 15% of sales. The equipment necessary for production will cost $4.7 million and will be depreciated according to a 3 year MACRS schedule. At the end of the project, the equipment can be scrapped for $500,000. Net working capital of $450,000 will be required immediately and will be recaptured at the end of the project. PUTZ has a 38% tax rate and teh required return on the project is 13%.   Required: What is the NPV of the project? First, calculate the taxes on the salvage value in order to calculate the aftertax salvage value to include in your capital spending analysis (at the end of the project). Taxes on salvage value = Market Price Tax on sale Aftertax salvage value                  -   Now we need to calculate the operating cash flow each year. Using the bottom up approach to calculating operating cash flow, we find: # of units per year 18,400 26,100 29,300 19,400 Year 0 Year 1 Year 2 Year 3 Year 4 Revenues Fixed costs Variable costs Depreciation EBT                     -                       -                       -                       -   Taxes                     -                       -                       -                       -   Net income                     -                       -                       -                       -   OCF                     -                       -                       -                       -   Capital spending                     -   Land NWC Total cash flow                  -                       -                       -                       -                       -   NPV Should the company proceed with the project, yes or no? Calculation for Deprecation: Year 1 Year 2 Year 3 Year 4 MACRS 3 years 33.33% 44.45% 14.81% 7.41%

Answer 1

		Year	0	1	2	3	4
		Salvage value of Equipment:
	A	Sales value					$500,000
	B=A*0.38	Tax on salvage					$190,000
	C=A-B	Cash flow due to salvage in year 4					$310,000
		Depreciation:
		Year	0	1	2	3	4
	D	MACRS 3 year depreciation rate		33.33%	44.45%	14.81%	7.41%
	E=D*4.7million			$        1,566,510	$       2,089,150	$         696,070	$       348,270
		Operating Cash Flow:
		Year	0	1	2	3	4
	F	Number of units per year		18400	26100	29300	19400
	G=F*$175	Sales Revenue		$        3,220,000	$       4,567,500	$     5,127,500	$   3,395,000
	H	Fixed Costs		$725,000	$725,000	$725,000	$725,000
	I=0.15*G	Variable Costs		$            483,000	$          685,125	$         769,125	$       509,250
	E	Depreciation		$        1,566,510	$       2,089,150	$         696,070	$       348,270
	J=G-H-I-E	EBIT		$            445,490	$       1,068,225	$     2,937,305	$   1,812,480
	K=J*0.38	Taxes		$            169,286	$          405,926	$     1,116,176	$       688,742
	L=J-K	Net Income		$            276,204	$          662,300	$     1,821,129	$   1,123,738
	M=L+E	Operating cash Flow(OCF)		$        1,842,714	$       2,751,450	$     2,517,199	$   1,472,008
	P	Capital Spending	($4,700,000)
	Q	Land	($2,100,000)
	R	NWC	($450,000)				$450,000
		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=Required Return=13%=	0.13
		N=Year of Cash Flow
	N	Year	0	1	2	3	4
	Z=C+M+P+Q+R	Total After Tax Cash Flow	($7,250,000)	$        1,842,714	$       2,751,450	$     2,517,199	$   2,232,008	SUM
	PV=Z/(1.13^N)	Present Value of Cash Flow	$       (7,250,000)	$        1,630,720	$       2,154,789	$     1,744,545	$   1,368,932	$ (351,014)
	NPV	Net Present Value=Sumof PVs=	$           (351,014)
		Should the Company Proceed with the project?
		Answer:NO,because NPV is negative