Question

In your first assignment in the Finance Division of Burr Habit Corporation, Susan Thomas, the executive vice president of finance and your boss, has asked you to evaluate the following capital budgeting decision. The firm is considering a new product line, insulated ski shorts. The company currently manufactures several lines of snow skiing apparel. The project requires an initial investment of $1.2 million in fixed assets and will last 5 years. These assets will be depreciated to a zero book value using the MACRS 3-year class schedule, even though the project will last for five years. Burr Habit Corp. expects to be able to sell this equipment for $5,000 at the end of the project. The firm has already spent $1,000,000 on research and development and $500,000 on market testing to determine the demand for this product. The new products, insulated ski shorts, are expected to generate sales of $2.5 million in the first year, with revenues increasing by 7% each year over the life of the project. Variable costs are expected to be 70% of sales. The new project will require that the company spend an additional $80,000 per year on insurance in case customers sue for frostbite. Also, a new marketing director would be hired to oversee the line at $45,000 per year in salary and benefits. Offering this product will force PLI to make additional investments in working capital. Projected end of the year balances appear in the table below. The marginal tax rate is 30% and the cost of capital for this project is 12%. Should Burr Habit Corp. go ahead with this project? Why or why not? Explain your answer.

Year 0 1 2 3 4 5 Accounts Receivable $0 $200,000 $250,000 $300,000 $350,000 $350,000 Inventory $0 500,000 650,000 780,000 800,000 800,000 Accounts Payable $0 250,000 300,000 425,000 450,000 450,000

Answer 1

The amount spend on research and development and market testing is sunk cost as the amount has already been spent and will not be considered in the NPV analysis.

Their is nothing mentioned regarding recovery of working capital at end of the project, I am assuming it will not be recovered. In case you get incorrect answer, try deducting the total working additional working capital at the end of the project.

Here is the solution -

NPV Rule : Higher the better

So, those projects should be selected which have a positive NPV. The firm should go for the project as we have a positive NPV.