Question

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 7,000, 7,700, 8,300, and 6,600 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $520 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 $735,000 per year, and variable costs are 20 percent of sales. The equipment necessary for production will cost $3.6 million and qualifies for 100 percent bonus depreciation in the first year. At the end of the project, the equipment can be scrapped for $605,000. Net working capital of $315,000 will be required immediately. PUTZ has a tax rate of 24 percent, and the required return on the project is 12 percent.

What is the NPV of the project?

Answer 1

Calculation of NPV of the project

We will first calculate the after tax salvage value of the Machine at the end of the project.

Salvage value = $605,000

Tax on salvage value = $ 605,000 * 24% = $ 145,200

After tax salvage value = 605,000 - 145,200 = $ 459,800

Calculation of operating cash flows:-

	Particulars	Year 0	year 1	year 2	year 3	year 4
a	Sales in units		7000	7700	8300	6600
b	Price per unit		520	520	520	520
c	Revenue a*b		3,640,000	4,004,000	4,316,000	3,432,000
d	variable cost(C@20%)		(728,000)	(800,800)	(863,200)	(686,400)
e	Fixed cost		(735,000)	(735,000)	(735,000)	(735,000)
f	Depreciation		(3,600,000)	0	0	0(
g	profit after Depreciation		(1,423,000)	2,468,200	2,717,800	2,010,600
h	Brought forward business losses set off		0	(1,423,000)	0	0
I	EBT		(1,423,000)	1,045,200	2,717,800	2,010,600
j	Tax@24%		0	(250,848)	(652,272)	(482,544)
K	net income or (lossl		(1,423,000)	794,352	2,065,528	1,528,056
L	Operating cash flows (k+f+h)		2,177,000 (-1,423,000+3,600,000+0)	2,217,352 (794252+0+1423,000)	2,065,528 (2,065,528+0+0)	1,528,056 (1,528,056+0+0)
m	Capital spending	(3,600,000)	0	0	0	0
n	Net working capital	(315,000	0	0	0	315,000
o	salvage value	0	0	0	0	459,800
p	total cash flows(l+m+n+o)	(3,915,000)	2,177,000	2,217,352	2,065,528	2,302,856
q	PV Factor @12%	1	0.8929	0.7972	0.7118	0.6355
r	present value	(3,915,000	1,943,843.3	1,767,673.01	1,470,242.83	1,463,464.99

Present value of cash outflows = 3,915,000

Present value of cash inflows = 1,943,843.3 + 1,767,673.01+ 1,470,242.83 + 1,416,464.99. = $ 6,645,224.13

NPV = present value of cash inflows - present value of cash outflows

NPV = $ 6,645,224.13 - $ 3,915,000 = $ 2,730,224.13