Question

The Ballpark Company is evaluating the market potential of brightly colored bowling balls. The results of an initial questionnaire that Ballpark has conducted in major markets six months ago and cost $50,000 were positive. A more comprehensive market test study that will cost an additional $250,000 was just completed and affirmed at least a 15% of the total bowling ball market. Ballpark has not yet paid for this study. Now Ballpark is at the point where it is considering investing in the assets needed to produce the colored balls. The balls would be produced in a building owned by the firm. The building, which was bought by Ballpark 20 years ago for $38,000, is currently vacant but it can be sold for $100,000. The value of the building on Ballpark’s books is $20,000. Ballpark can depreciate this $20,000 over two years on a straight-line basis. In order to estimate the market value of the building at project’s end, the company assumes that the price change will follow the trend experienced in the last 20 years. The land on which the building sits was bought for $32,000 twenty years ago and it is valued at $85,000 today. The expected appreciation in the land value is 5% per year over the coming ten-year period. Ballpark assumes that it will be able to sell both the building and the land together at their expected values at the end of the project’s life. The price of the new equipment needed is $570,000. It will require and additional $30,000 in shipping and installation costs. The useful life of the machine is 15 years but the company intends to use it for only the ten years that is the life of the project and then sell it at the termination of the project. It estimates its salvage value at $320,000. Production is estimated to be 23,400 units in the first year, rising by 18% per year for the following five years then falling by 8% per year for the remaining life of the project. The price of the balls in the first year will be $26. The bowling ball market is highly competitive and Ballpark believes that the price will increase by 3% per year. However, the plastic used to produce bowling balls is rapidly becoming more expensive. Variable production costs that will be $10 per unit in the first year will rise by 12% per year for the next four years then by 6% per year for the following five years. Total fixed costs excluding depreciation expense is assumed to stay constant at $300,000 per year for the life of the project. In addition, Ballpark is aware of the fact that some of the demand for its colored balls will be the result of shifting demand from its sales of the old black balls. It estimates that the new production will replace 2,000 units per year that bring in an after-tax EBIT of $8 per unit. The marginal tax rate applicable to this project is 25%. Ballpark anticipates that it will maintain an investment in working capital equal to $30,000 initially (at time point zero) and rising by 5% per year in the first seven years then declining by 15% in each of years eight and nine before is completely retrieved in year ten. Ballpark uses the straight line depreciation for all its depreciable assets. I) On an Excel spreadsheet, estimate the following: 1. Initial net investment (NINV) (show it clearly in one box) 2. Total after-tax salvage value (ATSV) for all assets (show details clearly in another box) 3. The annual depreciation schedule 4. The annual incremental investment in NWC 5. Annual free cash flows (FCF) At this point in the project, assume that the required rate of return on Ballpark’s project of similar risk is 17%. II) Use the capital budgeting decision criteria to decide which ones point to acceptance of the new project. Show in as much detail as possible on an Excel spreadsheet how you will evaluate the project including all estimates of cash flows and all the necessary calculations. Assume Ballpark uses a required payback of 6 years or less. III) Ballpark is not always comfortable with the estimate of its cost of capital so it uses a sensitivity analysis to check how robust its project valuations to various estimates of cost of capital. The estimate might start at 5% and increases by increments of 5% points until it reaches 30%. For each estimate an NPV is calculated to analyze the sensitivity of NPV to various discount rate assumptions. Plot the NPV profile (NPV on y-axis and discount rates on x-axis). Watch where the NPV curve intersects with the x-axis. What do you call the intersection point?

Answer 1

The Worksheet for Cash Flows of the Ballpark Company
	Details	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
1	Bowling Ball Machine*	(150,000)					36,351
2	Accumulated Depreciation		30,000	78,000	106,800	124,080	141,360
3	Adjusted basis of machine after depreciation (End of year)		120,000	72,000	43,200	25,920	8,640
4	Opportunity cost (warehouse)	(150,000)					150,000
5	Net working capital (end of year)	15,000	12,000	18,540	31,827	26,225	-
6	Change in net working capital	(15,000)	3,000	(6,540)	(13,287)	5,602	26,225
7	Total cash flow of investment (1+4+6)	(315,000)	3,000	(6,540)	(13,287)	5,602	212,577
	Income:
8	Sales Revenues		120,000	185,400	318,270	262,254	180,081
9	Operating Cost		(72,000)	(118,800)	(217,800)	(191,664)	(140,554)
10	Depreciation		(30,000)	(48,000)	(28,800)	(17,280)	(17,280)
11	Income before taxes		18,000	18,600	71,670	53,310	22,248
12	Tax @33%		5,940	6,138	23,651	17,592	7,342
13	Net income		12,060	12,462	48,019	35,718	14,906

*The salvage value of the capital investment at year 5 is $50000. The taxable amount is $41360 (50000-8640). The aftertax salvage value is 50000-(0.33*(50000-8640))=36351.2

Operating Revenues and Costs of the Baldwin Company
Year	Quantity Produced	Price	Sales Revenue	Cost per Unit	Operating Costs
1	6,000	20.00	120,000	12.00	72,000
2	9,000	20.60	185,400	13.20	118,800
3	15,000	21.22	318,270	14.52	217,800
4	12,000	21.85	262,254	15.97	191,664
5	8,000	22.51	180,081	17.57	140,554

Whether the project can be undertaken or not will depend on the Rate of return expectation of the company. In some cases payback approach is used to check the viability of the project while in some other cases NPV approach may be used. The NPV approach will again be dependent on the rate of return expectation. Though the project looks profitable, it may not be able to meet the expectations of a high Rate of return.