Question

You are the financial analyst for a tennis racket manufacturer. The company is considering using a graphite like material in its tennis rackets. The company has estimated the information in the following table about the market for a racket with the new material. The company expects to sell the racket for five years. The equipment required for the project has no salvage value. The required return for projects of this type is 14 percent, and the company has a 35 percent tax rate.

		Pessimistic				Expected				Optimistic
	Market size		119,000				134,000				159,000
	Market share		19	%			22	%			24	%
	Selling price	$	146			$	151			$	157
	Variable costs per unit	$	100			$	95			$	94
	Fixed costs per year	$	961,000			$	916,000			$	886,000
	Initial investment	$	1,570,000			$	1,485,000			$	1,400,000

Calculate the NPV for each case for this project. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Pessimistic		$
Expected		$
Optimistic		$

Answer 1

NPV: Net Present Value
NPV = PV of Cash Inflows - PV of Cash Outflows
If NPV > 0 , Project can be accepted
NPV = 0 , Indifference point. Project can be accepted/ Rejected.
NPV < 0 , Project will be rejected.

NPV Calculation:

Particulars	Pessimistic	Expected	Optimistic
Market size (Units)	1,19,000	1,34,000	1,59,000
Market share (%)	19%	22%	24%
Market share (Units)	22,610	29,480	38,160
Selling price per unit	146	151	157
Variable costs per unit	100	95	94
Contribution per unit = Selling price-Variable costs	46	56	63
Total contribution=Contribution per unit*Market share (units)	10,40,060	16,50,880	24,04,080
Fixed costs per year	9,61,000	9,16,000	8,86,000
Gross profit = Total contribution- Fixed costs	79,060	7,34,880	15,18,080
Tax charge @ 35% on gross profit	27,671	2,57,208	5,31,328
Net cash flows per year = Gross profit- Tax charge	51,389	4,77,672	9,86,752
Required return on the project	14%	14%	14%
PVAF for 5 years	26.96	26.96	26.96
Present value of future cash flows	13,85,232	1,28,76,033	2,65,98,694
Net present value (NPV)	-1,84,768	1,13,06,033	2,50,28,694

Both Optimistic and Expected have a positive NPV. If the company has to choose only one alternative, it has to go with Optimistic plan as this project has a higher NPV compared to Expected