Question

Using the Payback Method and NPV

The Scenario:You work in the product development department of an athletic apparel company.  Your company has decided to add a new product and is choosing between a polo tee, yoga pants, or running shoes. You have been asked to evaluate the financial profitability of each option.  You have estimated that the company has $2,000,000 to invest in the project, and each product has the potential to bring in an estimated $3,000,000 of future cash flows, although the timing of the cash flows varies per product.Additionally, two of the products would use equipment that could be sold at the end of the project cycle.  In order to pay for the project, the company will have to finance at a 6% interest rate. Present value discount factors are listed as follows:

Years	PV of 1 at 6%	PV of an Annuity at 6%
1	0.94340	0.94340
2	0.89000	1.83339
3	0.83962	2.67301
4	0.79209	3.46511
5	0.74726	4.21236

Formulas:

NPV = PV of total future net CF’s – initial cost

Requirements1.)Calculate the profitability of each project using

• The payback method
• Net present value (NPV)
• 2.)Make a decision on which product to produce by answering the Pause and Reflect questions on page 5.

Option 1: Polo Shirts

Future Net Cash Flows
Year 1	$600,000
Year 2	$600,000
Year 3	$600,000
Year 4	$600,000
Year 5	$600,000

Today’s Cash Outflows
Initial investment	$2,000,000

1. Calculate the payback period of polo shirts. In other words, how many years will it take for the company to recoup the initial investment?

2.) Calculate the NPV of polo shirts.

Option 2: Yoga Pants

Future Net Cash Flows
Year 1	$750,000
Year 2	$750,000
Year 3	$750,000
Year 4	$750,000
Salvage Value of Equipment Year 4	$50,000

Today’s Cash Outflows
Initial investment	$2,000,000

3.) Calculate the payback period of yoga pants.

Year	Annual Net Cash Flow	Cumulative Net Cash Flows
1
2
3
4

4.)Calculate the NPV of yoga pants.

NOTES: The company will receive the same $ cash flows for years 1-3. Use the PV of an annuity discount factor for this part of the calculation. In the 4^th year there is an additional cash flow (the salvage value).

Option 3: Running Shoes

Future Net Cash Flows
Year 1	$700,000
Year 2	$800,000
Year 3	$800,000
Year 4	$700,000
Salvage Value of Equipment Year 4	$50,000

Today’s Cash Outflows
Initial investment	$2,000,000

5. Calculate the payback period of running shoes.

Year	Annual Net Cash Flow	Cumulative Net Cash Flows
1
2
3
4

6.) Calculate the NPV of running shoes.

NOTES: Notice that every year the company will receive a different cash flow (Calculate the individual PV of each future cash flow and add them together).

Pause and Reflect:

1. Which product has the best NPV? Which has the best payback period? Is there anything about these results that surprises you?

2. If given the opportunity to choose between a higher NPV or a lower payback period, which would you choose and why?

3. Based on the information above, our company chooses to make _____________________

4. How did having a salvage value (such as with the yoga pants and running shoes) affect your payback and NPV calculations?

5. List two things that you learned from participating in this activity.

Answer 1