Question

The Bruin's Den Outdoor Gear is considering a new 6-year project to produce a new tent line. The equipment necessary would cost $1.31 million and be depreciated using straight-line depreciation to a book value of zero. At the end of the project, the equipment can be sold for 10 percent of its initial cost. The company believes that it can sell 24,000 tents per year at a price of $65 and variable costs of $25 per tent. The fixed costs will be $405,000 per year. The project will require an initial investment in net working capital of $197,000 that will be recovered at the end of the project. The required rate of return is 10.8 percent and the tax rate is 40 percent. What is the NPV?

Group choice of answers

a) $521,009

b) $613,002

c) $901,995

d) $370,295

e) $430,479

Answer 1

Annual depreciation = 1,310,000 / 6 = 218,333.3333

Initial investment = Cost + Increase in NWC

Initial investment = 1,310,000 + 197,000

Initial investment = 1,507,000

Sales = 24,000 * 65 = 1,560,000

Variable cost = 24,000 * 25 = 600,000

Operating cash flow from year 1 to year 6 = (Sales - variable costs - fixed costs - depreciation)(1 - tax) + depreciation

Operating cash flow from year 1 to year 6 = (1,560,000 - 600,000 - 405,000 - 218,333.3333)(1 - 0.4) + 218,333.3333

Operating cash flow from year 1 to year 6 = 336,666.667*0.6 + 218,333.3333

Operating cash flow from year 1 to year 6 = 420,333.3335

Sale value = 10% of 1,310,000 = 131,000

Year 6 non operating cash flow = Market value + recovery of NWC - tax(market value - book value)

Year 6 non operating cash flow = 131,000 + 197,000 - 0.4(131,000 - 0)

Year 6 non operating cash flow = 131,000 + 197,000 - 52,400

Year 6 non operating cash flow = 275,600

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

NPV = Annuity * [1 - 1 / (1 + r)^n] / r + FV / (1 + r)^n - Initial investment

NPV = 420,333.3335 * [1 - 1 / (1 + 0.108)^6] / 0.108 + 275,600 / (1 + 0.108)^6 - 1,507,000

NPV = 420,333.3335 * [1 - 0.540457] / 0.108 + 148,950.0492 - 1,507,000

NPV = 420,333.3335 * 4.255028 + 148,950.0492 - 1,507,000

NPV = $430,479