Question

Pinto Limited has recently been subject to significant competition from overseas manufacturers with much lower costs. To combat this, Pinto is considering a project that will see it move into a new product market considered riskier than its current operations. The CEO has asked you to undertake a financial analysis of the proposed project and present your recommendations in a short memo. As part of your financial analysis you will calculate NPV, IRR, payback period, discounted payback period and profitability index. The project requires an upfront investment in plant and equipment of $15 million, which will be depreciated on a straight-line basis over the five-year life of the project. The equipment is not expected to have any significant salvage value at the end of its depreciable life. Pinto paid $25,000 in fees to consultants for a market analysis related to the project. This analysis predicted sales volume of 200,000 units in the first year, which would grow by 50% per year in years two and three, and fall by 50% in each remaining year as demand wanes. Selling price in the first year is expected to be $75 and grow by 3% each year after that. Pinto’s operations manager has estimated cost of goods sold for the project will equal 60% of sales revenues and selling, general and administrative expenses directly related to the project (excluding depreciation) will be $1 million in the first year and increase by 5% per year thereafter. The operations manager has not included in his estimates any cost for a project operations base because the plan is to use a building the company already owns. Currently Pinto rents this building to another company for $250,000 per year. The project will require an upfront investment in net working capital equal to 20% of the year 1 sales revenue forecast. This investment in working capital will be fully recovered at the end year 5. The company has a 10% weighted average cost of capital and is subject to a 30% tax rate.

Answer 1

Let us start with preparing a PnL estimate for the project. This is required to compute the taxes. The PnL would look like the below.

The cash flows will look like

Once we have all the cash flow projects, we can compute the required parameters.

Discounted

(18,025,000)

3,779,545

5,292,562

7,440,838

3,416,978

3,311,427

NPV is the sum of discounted cash flows. NPV = $ 5,216,350

IRR = 20.42% (IRR is the discount rate which makes NPV to be zero)

Payback period lies somewhere b/w 2 and 3 years

Total recovery after 2 years = 10,561,500

Total recovery after 3 years = 20,465,225

so, payback of $ 18,025,000 after 2.75 years

Payback period = 2.75 years

Discounted payback, we will use discounted cashflows to compute the payback period

Discounted payback period = 2.90 years