Question

Vandelay Industries is evaluating a project that costs $1,350,000 and has a 20 year life.

Depreciation will be straight-line to zero over the life of the project. Management believes they

will be able to sell the equipment at the end of the project for $50,000. Sales are projected to be

50,000 units in the first year, 70,000 units in the second year, and 25,000 units for all additional

years. Price per unit is $34.50, variable cost per unit is $15.50 and fixed costs are $300,000 per

year. The project also requires an initial investment in net working capital of $150,000 and for

the project to maintain a net working capital balance equal to $150,000 plus 15% of sales while

the project is ongoing. All net working capital will be recouped at the end of the project. This

project will have an additional spillover effect that will impact existing sales negatively. The net

pre-tax impact of the spillover effect will be -$75,000 per year. This project will also have a

positive spillover effect. Specifically, the project will generate additional sales of 100 units of an

existing product at a price of $15 each. The existing product has variable costs of $9 and fixed

costs of $5,000 per year. The company’s marginal tax rate is 35%. The required return on

similar projects is 11%.

a. What is the project’s NPV?

b. What is the project’s payback period?

c. What is the project’s profitability index?

d. Why might this company decide to pursue this project?

Answer 1