Question

CT25.2 Hawke Skateboards is considering building a new plant. Bob Skerritt, the company's marketing manager, is an enthusiastic supporter of the new plant. Lucy Liu, the company's chief financial officer, is not so sure that the plant is a good idea. Currently, the company purchases its skateboards from foreign manufacturers.

The following figures were estimated regarding the construction of a new plant.

Cost of plant                                         $4,000,000   

Estimated useful life                               15 years

Annual cash inflows                                   4,000,000

Salvage value                                               $2,000,000

Annual cash outflows                                3,540,000

Discount rate                                                           11%

Bob Skerritt believes that these figures understate the true potential value of the plant. He suggests that by manufacturing its own skateboards the company will benefit from a “buy American” patriotism that he believes is common among skateboarders.

He also notes that the firm has had numerous quality problems with the skateboards manufactured by its suppliers. He suggests that the inconsistent quality has resulted in lost sales, increased warranty claims, and some costly lawsuits.

Overall, he believes sales will be $200,000 higher than projected above, and that the savings from lower warranty costs and legal costs will be $60,000 per year. He also believes that the project is not as risky as assumed above, and that a 9% discount rate is more reasonable.

Instructions Answer each of the following.

1. Compute the net present value of the project based on the original projections. b. Compute the net present value incorporating Bob's estimates of the value of the intangible benefits, but still using the 11% discount rate.
2. Compute the net present value using the original estimates, but employing the 9% discount rate that Bob suggests is more appropriate.
3. Comment on your findings.

Answer 1

HAWKE SKATEBOARD Workings Cost of Plant Salvage Value Depreciable Value Useful life (Years) 40,00,000 20,00,000 20,00,000 15 1,33,333.33 Annual Depreciation (1,600,000 / 15) $ a) Annual Cash Inflows Annual Cash Outflows Net Cash Inflow (4,000,000 - 3,540,000) 40,00,000 35,40,000 4,60,000 $ Calculation of Net Present Value of Plant with 11% Discount Rate Net Cash inflow per year PVAF (11%, 15 years) 4,60,000 7.19087 33,07,800 4,18,000 Add: Salvage Value, PVF (11%, 15) (2,000,000 x 0.20900) Total Less : Cost of Plant Net Present Value 37,25,800 40,00,000 -2,74,200 $ The project should be rejected

b) Annual Cash Inflows Annual Cash Outflows Net Cash Inflow Old Cases Adjustments $ 40,00,000 $ 2,00,000 35,40,000 -60,000 $ 4,60,000 New Estimate $ 42,00,000 3 4,80,000 $ 7,20,000 Calculation of Net Present Value of Plant with 11% Discount Rate $ Net Cash inflow per year PVAF (11%, 15 years) 7,20,000 7.19087 51,77,426 4,18,000 Add: Salvage Value, PVF (11%, 15) (2,000,000 x 0.20900) Total Less : Cost of Plant Net Present Value $ 55,95,426 40,00,000 15,95,426 $ The project should be accepted

c) Calculation of Net Present Value of original estimats with 9% Discount Rate $ Net Cash inflow per year PVAF (9%, 15 years) 4,60,000 8.0607 37,07,922 5,49,080 Add: Salvage Value, PVF (9%, 15) (2,000,000 x 0.27454) Total Less: Cost of Plant Net Present Value $ 42,57,002 40,00,000 2,57,002 $ The project should be accepted