Question

- You have been hired as a capital budgeting analyst by a sporting good firm that manufactures athletic shoes

- And has captured 10% of the overall shoe market.

- The total market value is worth $100 million a year.

- The fixed costs associated with manufacturing these shoes is $2 million a year

- And variable costs are 40% of the revenues.

- The company’s tax rate is 40%.

- The firm believes that it can increase its market share to 20% by investing $10 million in a new distribution system

- which can be depreciated over the system’s life of 10 years to a salvage value of zero

- And spending $1 million a year on additional advertising.

- The company proposes to continue to maintain working capital at 10% of annual revenues.

- The discount rate used for this project is 8%.

a) What is the initial investment for this project?

b) What is the annual operating cash flow from this project?

c) What is the NPV of this project?

THANK YOU!

Answer 1

Answer a
Initial investment for the project = Investment in new distribution system + Additional working capital = $10 million + $1 million = $11 million
Answer b
Calculation of annual operating cash flow from this project
	Millions
Additional sales (10% of $100 million)	$10.00
Less : Variable cost	$4.00
Contribution Margin	$6.00
Less : Fixed cost
- Additional advertising	$1.00
- Depreciation [$10 million / 10 years]	$1.00
Annual Operating Income	$4.00
Less : Tax @ 40%	$1.60
Net Income	$2.40
Add : Depreciation	$1.00
Annual Operating Cash flow	$3.40
Answer c
NPV of the project (in million)
Year	0	1	2	3	4	5	6	7	8	9	10	NPV
Investment in new distribution system	-$10.00
Operating Cash flow		$3.40	$3.40	$3.40	$3.40	$3.40	$3.40	$3.40	$3.40	$3.40	$3.40
Additional working capital	-$1.00
Net Cash flow	-$11.00	$3.40	$3.40	$3.40	$3.40	$3.40	$3.40	$3.40	$3.40	$3.40	$3.40
Discount factor @ 8%	$1.00	$0.93	$0.86	$0.79	$0.74	$0.68	$0.63	$0.58	$0.54	$0.50	$0.46
Present Values	-$11.00	$3.15	$2.91	$2.70	$2.50	$2.31	$2.14	$1.98	$1.84	$1.70	$1.57	$11.81
NPV of this project = $11.81 million