Question

You are considering adding new elliptical trainers to your firm's product line of fitness equipment, and you feel you can sell 8,000 of these per year for five years (after which time this project is expected to shut down when it is learned that being fit is unhealthy). Each elliptical trainer would have variable costs of $500 and sell for $900; annual fixed costs associated with production would be $1,600,000. In addition, there would be a $3,500,000 initial expenditure associated with the purchase of new production equipment. It is assumed that the simplified straight-line method would be used to depreciate this initial expenditure down to zero over five years. This project will also require a one-time initial investment of $500,000 in net working capital associated with inventory, and this working capital investment will be recovered when the project is shut down. Finally, the firm's marginal tax rate is 24 percent. ***UPDATES*** The introduction of the new elliptical trainers will have a negative impact on the sales of their existing elliptical trainers by 1,000 units each year. These existing trainers have a unit sales price of $800 and a variable unit cost of $450. a. What is the initial cash outlay associated with this project? b. What are the annual net cash flows associated with this project for years 1-4? c. What is the terminal cash flow in year 5 (that is, what is the free cash flow in year 5 plus any additional cash flows associated with the termination of the project?) d. What is the projects NPV given a 10% required rate of return?

Answer 1

Answer (a) – Intial Outlay of the Project will be:

Cost of New Equipment = $3,500,000

Working Capital = $500,000

Total Outlay = $4,000,000            

Answer (b) – Net Cash Flow for the project

A	Unit Sale Price	A	$900
B	Variable Cost	B	$500
C	Contribution	C =A-B	$400
D	Unit Sold	D	$8000
E	Total Contribution	E = C*D	$3200000
F	Fixed Cost	F	$1600000
G	Depreciation	G = 3500000/5	$700000
H	Profit Before Tax	H=E-F-G	$900000
I	Tax 24%	I= H*24%	$216000
J	Profit After Tax	J=H-I	$684000
	Depreciation	G	$700000
K	Net Cash Flow After Tax	K =J+G	$1384000

Net Cash Flow After Tax = $1384000

Answer (c) – Terminal Cash Flow for the project

Salvage Value = 0

Working Capital = $500,000

5^th Year Cash Flow = $1384000 + $500,000 = $1884000

Answer (d) – NPV for the project

	Year	Cash Flow	Present Value@10%	Present Value
A	0	(4000000)	1	(4000000.00)
B	1-4	1384000	3.1698	4387003.20
C	5	1884000	0.6209	1169775.60
	NPV			(A+B+C) = 1556778.80