Question

Part 2

Please study the following capital budgeting project and then provide explanations for the questions outlined below:

You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago for $2.1 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $2.3 million on an after-tax basis. In four years, the land could be sold for $2.4 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $125,000. An excerpt of the marketing report is as follows:

The zither industry will have a rapid expansion in the next four years. With the brand name recognition that PUTZ brings to bear, we feel that the company will be able to sell 3,600, 4,300, 5,200, and 3,900 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $750 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued. PUTZ believes that fixed costs for the project will be $415,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $3.5 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $350,000. Net working capital of $125,000 will be required immediately. PUTZ has a 38% tax rate, and the required rate of return on the project is 13%.

Now please provide detailed explanation for the following:

• Explain how you determine the initial cash flows

• Discuss the notion of sunk costs and identify the sunk cost in this project

• Verify how you determine the annual operating cash flows

• Explain how you determine the terminal cash flows at the end of the project’s life

• Calculate the NPV and IRR of the project and decide if the project is acceptable

• If the company that is implementing this project is a publicly traded company, explain and justify how this project will impact the market price of the company’s stock

Provide your explanations and definitions in detail and be precise.

Answer 1

Sunk cost is a cost that has already been incurred and the outcome of any project decision does not change because of this cost. Here the cost of $125,000 incurred on the marketing firm to analyze zither market is a sunk cost as the cash flows of the project and the decision to accept or reject the project does not depend on the cost.

PUTZ
Capital Investment Apprisal
Opportunity cost of Land
Current Sale value of land =	$        2,300,000
Land sale value after 4 years =	$        2,400,000
PV of Land Sale val;ue after 4 years @13%=2.4/1.13^4=	$1,471,965
NPV of Opportunity Loss=	$828,035

MACRS Depreciation in 3 Yrs Rate	Year 0	Year 1	Year 2	Year 3	Year 4
		33.33%	44.45%	14.81%	7.41%
Annual Depreciation on $3.5M Equipment=		$     1,166,550	$            1,555,750	$         518,350	$          259,350
Sales Plan of Project
Sales Units		3600	4300	5200	3900
Sales Revenue @$750/unit		$     2,700,000	$            3,225,000	$     3,900,000	$      2,925,000

  

	NPV Evaluation	Year 0	Year 1	Year 2	Year 3	Year 4
	Initial Investment
	Equipment Cost	$      (3,500,000)
	Opportunity cost of Land	$         (828,035)
	Incremental NWC	$         (125,000)
a	Total Initial Investment	$      (4,453,035)
	Cash flow from Operations
	Sales Revenue		$     2,700,000	$            3,225,000	$     3,900,000	$      2,925,000
	Less Variable cost @15% of sales		$        405,000	$               483,750	$         585,000	$          438,750
	Less Fixed cost		$        415,000	$               415,000	$         415,000	$          415,000
	Less Depreciation		$     1,166,550	$            1,555,750	$         518,350	$          259,350
	EBT		$        713,450	$               770,500	$     2,381,650	$      1,811,900
	Tax @38%		$        199,766	$               215,740	$         666,862	$          507,332
	Post Tax Income		$        513,684	$               554,760	$     1,714,788	$      1,304,568
	Add Back depreciation		$     1,166,550	$            1,555,750	$         518,350	$          259,350
b	Operating Cash flow		$     1,680,234	$           2,110,510	$     2,233,138	$      1,563,918

	Terminal Cash flows
	Return of Net working Capital					$          125,000
	Post tax Salavage value =350000*(1-38%)=					$          217,000
c	Total Terminal Cash flow					$         342,000
d	Total Cash flow =a+b+c	$      (4,453,035)	$     1,680,234	$            2,110,510	$     2,233,138	$      1,905,918
e	PV factor @13%=1/1.13^n	1	0.8850	0.7831	0.6931	0.6133
f	PV of Cash flows=d*e=	$   (4,453,035.1)	$ 1,487,007.1	$        1,652,740.4	$ 1,547,787.9	$   1,168,899.5
g	NPV =Sum of PV of cash flows=	$    1,403,399.9

At Discount rate 27.01674%, the NPV is zero as	=NPV(27.01674%,G590,H590,I590,J590)+F590
per the excel function , so IRR is 27.01674%
The project is acceptable as the NPV is positive and the IRR is above the minimum required rate of return.

If the company implementing the project is a publicly traded company , the project will help in increasing the
share price of the company's stock. The positive news of the good NPV and high IRR will be anticipated as
indications of higher future earnings of the company, and that positive signal will increase the share price.