Question

Vandelay Industries is evaluating a project that costs $1,350,000 and has a 20 year life.  Depreciation will be straight-line to zero over the life of the project. Management believes they will be able to sell the equipment at the end of the project for $50,000.  Sales are projected to be 50,000 units in the first year, 70,000 units in the second year, and 25,000 units for all additional years.  Price per unit is $34.50, variable cost per unit is $15.50 and fixed costs are $300,000 per year.  The project also requires an initial investment in net working capital of $150,000 and for the project to maintain a net working capital balance equal to $150,000 plus 15% of sales while the project is ongoing.  All net working capital will be recouped at the end of the project.  This project will have an additional spillover effect that will impact existing sales negatively.  The net pre-tax impact of the spillover effect will be -$75,000 per year.  This project will also have a positive spillover effect.  Specifically, the project will generate additional sales of 100 units of an existing product at a price of $15 each.  The existing product has variable costs of $9 and fixed costs of $5,000 per year. The company’s marginal tax rate is 35%. The required return on similar projects is 11%.

1) What is the project’s NPV?

2) What is the project’s payback period?

3) What is the project’s profitability index?

4) Why might this company decide to pursue this project?

Answer 1

Tax rate	35%
	Year-1	Year-2	Year-3-20
Units	50,000	70,000	25,000
Sale Price	34.50	34.50	34.50
variable cost	15.50	15.50	15.50
Sale	1,725,000	2,415,000	862,500
Less: Operating Cost	775,000	1,085,000	387,500
Contribution	950,000	1,330,000	475,000
Less: Fixed Cost	300,000	300,000	300,000
Less: Depreciation 1350000/20	67,500	67,500	67,500
Profit before tax	582,500	962,500	107,500
Tax	203,875	336,875	37,625
Profit After Tax	378,625	625,625	69,875
Add Depreciation	67,500	67,500	67,500
Cash Profit After tax	446,125	693,125	137,375
Spillover effect negative	(75,000)	(75,000)	(75,000)
Spillover effect positive
Sale- 15
Less Variable cost-9
Units-100
Total contribution 100*(15-9)=600	600	600	600
cash flows	(74,400)	(74,400)	(74,400)
Tax impact	(26,040)	(26,040)	(26,040)
After tax impact	(48,360)	(48,360)	(48,360)
Operating profit adjusted with spillover	397,765	644,765	89,015
Working capital-opening	150,000	408,750	512,250
Closing working capital	408,750	512,250	279,375
Movement	(258,750)	(103,500)	232,875
Cost of macine		1,350,000
Depreciation		1,350,000
WDV		-
Sale price		50,000
Profit/(Loss)		50,000
Tax		17,500
Sale price after tax		32,500
Calculation of NPV
					11%
Year	Captial	Working captial	Operating cash	Annual Cash flow	PV factor	Present values	Cumulative cash flows
0	(1,350,000)	(150,000)		(1,500,000)	1.000	(1,500,000)	(1,500,000)
1		(258,750)	397,765	139,015	0.901	125,239	(1,360,985)
2		(103,500)	644,765	541,265	0.812	439,303	(819,720)
3		232,875	89,015	321,890	0.731	235,363	(497,830)
4			89,015	89,015	0.659	58,637	(408,815)
5			89,015	89,015	0.593	52,826	(319,800)
6			89,015	89,015	0.535	47,591	(230,785)
7			89,015	89,015	0.482	42,875	(141,770)
8			89,015	89,015	0.434	38,626	(52,755)
9			89,015	89,015	0.391	34,798	36,260
10			89,015	89,015	0.352	31,350	125,275
11			89,015	89,015	0.317	28,243	214,290
12			89,015	89,015	0.286	25,444	303,305
13			89,015	89,015	0.258	22,923	392,320
14			89,015	89,015	0.232	20,651	481,335
15			89,015	89,015	0.209	18,605	570,350
16			89,015	89,015	0.188	16,761	659,365
17			89,015	89,015	0.170	15,100	748,380
18			89,015	89,015	0.153	13,603	837,395
19			89,015	89,015	0.138	12,255	926,410
20	32,500	279,375	89,015	400,890	0.124	49,724	1,327,300
				Net Present Value		(170,084)
Calculation of payback period
	Payback period	= 8 + (52755/89015)
	Year	8.59
Calculation of profitability index	Sum of PV of inflows/Sum of PV of outflow
	1329916/1500000
	0.89
Since NPV is negative and PI is less than 1, it is not recommonded to take up the project