Question

Expand Your Critical Thinking 25-02 d (Essay)

	Your answer has been saved and sent to the instructor. See Gradebook for score details.

Hawke Skateboards is considering building a new plant. Bob Skerritt, the company’s marketing manager, is an enthusiastic supporter of the new plant. Lucy Liu, the company’s chief financial officer, is not so sure that the plant is a good idea. Currently, the company purchases its skateboards from foreign manufacturers. The following figures were estimated regarding the construction of a new plant.

Cost of plant		$4,000,000		Estimated useful life		15 years
Annual cash inflows		4,000,000		Salvage value		$2,000,000
Annual cash outflows		3,540,000		Discount rate		11%

Bob Skerritt believes that these figures understate the true potential value of the plant. He suggests that by manufacturing its own skateboards the company will benefit from a “buy American” patriotism that he believes is common among skateboarders. He also notes that the firm has had numerous quality problems with the skateboards manufactured by its suppliers. He suggests that the inconsistent quality has resulted in lost sales, increased warranty claims, and some costly lawsuits. Overall, he believes sales will be $200,000 higher than projected above, and that the savings from lower warranty costs and legal costs will be $60,000 per year. He also believes that the project is not as risky as assumed above, and that a 9% discount rate is more reasonable.

		NPV
Based on original projections		$(274,200)
New projections using the 11% rate		$1,595,426
Original projections using the 9% rate		$256,997

(d)

Comment on the Net present values.

Answer 1

Answer:

(a)      Using the original estimates, the present value is calculated as follows:

		Cash Flows	X	11% Discount Factor	=	Present Value
Present value of net annual cash flows Present value of salvage value Capital investment Net present value		$  460,000a  2,000,000	X X	7.19087  .20900	= =	($3,307,800) (   418,000) (3,725,800 (4,000,000) ($  (274,200)

          ^aNet annual cash flows = $4,000,000 – $3,540,000

          The negative net present value of the project suggests that it should be rejected.

(b)      Using the revised estimates, the net present value is calculated as follows:

		Cash Flows	X	11% Discount Factor	=	Present Value
Present value of net annual cash flows Present value of salvage value Capital investment Net present value		b$  720,000b  2,000,000	X X	7.19087  .20900	= =	$5,177,426    418,000 5,595,426 (4,000,000) $1,595,426

          ^bNet annual cash flows = $4,200,000 – $3,480,000

          Under these revised estimates, the project should be accepted.

(c)      Using the original estimates, but a 9% discount rate, the net present value is calculated as follows:

		Cash Flows	X	9% Discount Factor	=	Present Value
Present value of net annual cash flows Present value of salvage value Capital investment Net present value		c$  460,000c  2,000,000	X X	8.06069  .27454	= =	$3,707,917    549,080 $4,256,997 (4,000,000) $  256,997

          ^cNet annual cash flows = $4,000,000 – $3,540,000

          Using the original estimates, but the lower discount rate, the net present value is positive, suggesting the project should be accepted.

(d)     If Bob is correct in either his belief that the estimated net annual cash flows are too conservative, or that the discount rate being used is too high, then the project is acceptable. At a minimum, this analysis suggests that further investigation is warranted.