Question

J. Smythe, Inc., manufactures fine furniture. The company is deciding whether to introduce a new mahogany dining room table set. The set will sell for $6,150, including a set of eight chairs. The company feels that sales will be 3,000, 3,150, 3,700, 3,550, and 3,300 sets per year for the next five years, respectively. Variable costs will amount to 46 percent of sales and fixed costs are $1,930,000 per year. The new tables will require inventory amounting to 14 percent of sales, produced and stockpiled in the year prior to sales. It is believed that the addition of the new table will cause a loss of 300 tables per year of the oak tables the company produces. These tables sell for $4,600 and have variable costs of 41 percent of sales. The inventory for this oak table is also 14 percent of sales. The sales of the oak table will continue indefinitely. J. Smythe currently has excess production capacity. If the company buys the necessary equipment today, it will cost $21,000,000. However, the excess production capacity means the company can produce the new table without buying the new equipment. The company controller has said that the current excess capacity will end in two years with current production. This means that if the company uses the current excess capacity for the new table, it will be forced to spend the $21,000,000 in two years to accommodate the increased sales of its current products. In five years, the new equipment will have a market value of $3,200,000 if purchased today, and $8,200,000 if purchased in two years. The equipment is depreciated on a seven-year MACRS schedule. The company has a tax rate of 22 percent and the required return for the project is 16 percent. MACRS schedule

  

Calculate the NPV of new project.

Answer 1

	Calculation of Net Present value		1	2	3	4	5
	Sale units		3000	3150	3700	3550	3300
	Selling price per set		6150	6150	6150	6150	6150
			18450000	19372500	22755000	21832500	20295000
	Variable cost @ 46%		-8487000	-8911350	-10467300	-10042950	-9335700
	Fixed cost		-1930000	-1930000	-1930000	-1930000	-1930000
	Working capital requirement@14%		-2583000	-2712150	-3185700	-3056550	-2841300
	Loss of 300 tables net of tax 300*4600*(100%-41%)(100%-22%)		-635076	-635076	-635076	-635076	-635076
	Working capital requirement@14% for table 300*4600*14%		-193200	-193200	-193200	-193200	-193200
	Cost of equipment				-21000000
	Tax savings on depreciation (WN 1)				4620000	3959802	2990046
	Salvage value after tax (WN 2)						7536913
	Total inflows/outflows		4621724	4990724	-10036276	9934526	15886683
	Cost of capital @ 16%		0.862	0.743	0.64	0.552	0.476
	Present value		3983926	3708108	-6423217	5483858	7562061
	Net Present value of new project	14314737

MACRS 7 year schedule rate: This schedule has the standard rates which are as follows. In question it is given that asset will be purchased after two years. Only years will be remaining after 3 years out of 5 years. Here we will prepare the schedule o the basis of 3 years.

WN-1	Year	Rate	Opening balance	Depreciation	Closing balance	Tax savings on depreciation
	1	14.29%	21000000	3000900	17999100	4620000
	2	24.49%	17999100	4407980	13591120	3959802
	3	17.49%	13591120	2377087	11214033	2990046
	Total depreciation			9785967
WN-2	Book value of asset	21000000
	Less depreciation	9785967
	Salvage value at the end of 5 year	8200000
	Gain on sale of asset	3014033
	Tax @22%	663087
	Salvage value after tax	7536913