Question

3.  

Smith, Inc. has stumbled on a catchy new product. It recognizes that the product will be a fad, and as such will not continue to generate sales in the long run, but it wants your assessment of whether it should proceed anyway. Smith recently hired a consulting firm at a cost of $200,000. The consulting firm’s report indicates that Smith could anticipate selling 3,700, 4,000, 4,200, and 1,700 units over the upcoming four years, all at a premium price of $800 per unit. For simplicity assume that collections (as well as production costs and expenses) occur at the end of each year.  

The project would involve fixed production costs of $425,000 per year, as well as selling and administrative expenses equal to 13% of sales. In addition, Smith would have to invest $120,000 in working capital right away, though it would expect to recover the working capital at the end of the project. Production equipment would also have to be acquired right away, at a cost of $4.4 million. The equipment would be depreciated according to the 3-year MACRS schedule, and would have a salvage value of $450,000.

Smith acquired land that would be suitable for the production facilities two years ago, at a price of $1 million. The current after-tax value of the land is $800,000. Smith anticipates that the land would appreciate in value back to $1 million by the time the project was completed in four years. Smith's tax rate is 34%, and it has determined that a 13% discount rate is appropriate.

Compute the incremental cash flows that would result from a decision to proceed with the product, and the project’s NPV.

Answer 1

Solution) CalculatIon for NPV is given below

Tax rate	34%	Discount Rate	13%
Time Peroid	4			Year	Beginning Balance	Dep Rate	Dep Amt	Ending Balance
Cash Outlay	4400000			1	4400000	33.33%	1466520	2933480
Salvage Value	450000			2	2933480	44.45%	1303931.86	1629548.14
				3	1629548.14	14.81%	241336.0795	1388212.06
				4	1388212.06	7.41%	102866.5137	1285345.547
Investment Outlays at Time Zero:				0	1	2	3	4
Equipment				$ 4,400,000
Operating Cash Flows over the Project's Life:
Unit Sold					3,700	4,000	4,200	1,700
Price					800	800	800	800
Sales revenue					$            2,960,000	$      3,200,000	$     3,360,000	$   1,360,000
Fixed operating costs					$                425,000	$          425,000	$        425,000	$      425,000
Adminstrative expenses					$                384,800	$          416,000	$        436,800	$      176,800
Depreciation (equipment)					$            1,466,520	$      1,303,932	$        241,336	$      102,867
Oper. income before taxes (EBIT)					$                683,680	$      1,055,068	$     2,256,864	$      655,333
Taxes on operating income (34%)					$                232,451	$          358,723	$        767,334	$      222,813
Net Operating Profit After Taxes (NOPAT)					$                451,229	$          696,345	$     1,489,530	$      432,520
Add back depreciation					$            1,466,520	$      1,303,932	$        241,336	$      102,867
Operating cash flow					$            1,917,749	$      2,000,277	$     1,730,866	$      535,387
Need in Working capital				120,000
Terminal Year Cash Flows:
Net salvage value								450,000
Net Cash Flow (Time line of cash flows)				($4,520,000)	$1,917,749	$2,000,277	$1,730,866	$985,387
Net Present Value (at 13%)			$547,566