Question

You are considering launching a new product, and you believe you can sell 5000 these per year for 5 years after which time this product line will shut down. The product would sell for $100 each, with variable costs of $60 for each one produced, and annual fixed costs associated with production would be $100,000. In addition, there would be a $250000 initial expenditure associated with the purchase of new production equipment. It is assumed this initial expenditure will be depreciated using the straight-line method down to zero over 5 years. The market value of the equipment at the end of 5 years will be zero. The project will also require a one-time initial investment of $50000 in net working capital associated with inventory, and this working capital investment will be recovered when the project is shut down. Finally, assume the firm’s marginal tax rate is 30%. (a) What is the initial cash outlay associated with this project? (b) What are the annual net cash flows associated with this project for years 1 to 4? (13) (c) What is the terminal cash flow in year 5 (i.e. what is the free cash flow in year 5 plus any additional cash flows associated with termination of the project)? (d) What is the project’s NPV given a 10% required rate of return?

Answer 1

a) Initial cash outflow of year 0 = $ 300000

b) Net cashflows

Year 1 = $ 100000

Year 2 = $ 100000

Year 3 = $ 100000

Year 4 = $ 100000

c) Terminal cashflow of year 5 = $ 150000

d) Net Present Value = $ 105550

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