Question

Expand Your Critical Thinking 25-02 a-c

Hawke Skateboards is considering building a new plant. Bob Skerritt, the company’s marketing manager, is an enthusiastic supporter of the new plant. Lucy Liu, the company’s chief financial officer, is not so sure that the plant is a good idea. Currently, the company purchases its skateboards from foreign manufacturers. The following figures were estimated regarding the construction of a new plant.

Cost of plant		$3,360,000		Estimated useful life		15 years
Annual cash inflows		3,360,000		Salvage value		$1,680,000
Annual cash outflows		2,974,000		Discount rate		11%

Bob Skerritt believes that these figures understate the true potential value of the plant. He suggests that by manufacturing its own skateboards the company will benefit from a “buy American” patriotism that he believes is common among skateboarders. He also notes that the firm has had numerous quality problems with the skateboards manufactured by its suppliers. He suggests that the inconsistent quality has resulted in lost sales, increased warranty claims, and some costly lawsuits. Overall, he believes sales will be $168,000 higher than projected above, and that the savings from lower warranty costs and legal costs will be $50,000 per year. He also believes that the project is not as risky as assumed above, and that a 9% discount rate is more reasonable.

1: Compute the net present value of the project based on the original projections

2: Compute the net present value incorporating Bob’s estimates of the value of the intangible benefits, but still using the 11% discount rate

3:Compute the net present value using the original estimates, but employing the 9% discount rate that Bob suggests is more appropriate.

Answer 1

Part 1

Year	PV factor @ 11%	Remarks
1	0.90090	= 1 / 1.11
2	0.81162	= 0.9009 / 1.11
3	0.73119	= 0.81162 / 1.11
4	0.65873	= 0.73119 / 1.11
5	0.59345	= 0.65873 / 1.11
6	0.53464	= 0.59345 / 1.11
7	0.48166	= 0.53464 / 1.11
8	0.43393	= 0.48166 / 1.11
9	0.39092	= 0.43393 / 1.11
10	0.35218	= 0.39092 / 1.11
11	0.31728	= 0.35218 / 1.11
12	0.28584	= 0.31728 / 1.11
13	0.25751	= 0.28584 / 1.11
14	0.23199	= 0.25751 / 1.11
15	0.20900	= 0.23199 / 1.11
Total	7.19087

Annual cash inflows	3,360,000
Less: Annual cash outflows	2,974,000
Net annual cash flows	386,000
	Amount	Multiply: PV factor	Present value
Cost of plant	(3,360,000)	1.00000	(3,360,000)
Net annual cash flows	386,000	7.19087	2,775,676
Salvage value	1,680,000	0.20900	351,120
Net present value			(233,204)
This project should be rejected.			Rejected
[Negative NPV is rejected]

Part 2

Annual cash inflows (3360000+168000)	3,528,000
Less: Annual cash outflows (2974000-50000)	2,924,000
Net annual cash flows	604,000
	Amount	Multiply: PV factor	Present value
Cost of plant	(3,360,000)	1.00000	(3,360,000)
Net annual cash flows	604,000	7.19087	4,343,285
Salvage value	1,680,000	0.20900	351,120
Net present value			1,334,405
This project should be Accepted			Accepted
[Positive NPV is accepted]

Part 3

Year	PV factor @ 9%	Remarks
1	0.91743	= 1 / 1.09
2	0.84168	= 0.91743 / 1.09
3	0.77218	= 0.84168 / 1.09
4	0.70843	= 0.77218 / 1.09
5	0.64993	= 0.70843 / 1.09
6	0.59627	= 0.64993 / 1.09
7	0.54703	= 0.59627 / 1.09
8	0.50187	= 0.54703 / 1.09
9	0.46043	= 0.50187 / 1.09
10	0.42241	= 0.46043 / 1.09
11	0.38753	= 0.42241 / 1.09
12	0.35553	= 0.38753 / 1.09
13	0.32618	= 0.35553 / 1.09
14	0.29925	= 0.32618 / 1.09
15	0.27454	= 0.29925 / 1.09
Total	8.06069

Annual cash inflows	3,360,000
Less: Annual cash outflows	2,974,000
Net annual cash flows	386,000
	Amount	Multiply: PV factor	Present value
Cost of plant	(3,360,000)	1.00000	(3,360,000)
Net annual cash flows	386,000	8.06069	3,111,426
Salvage value	1,680,000	0.27454	461,227
Net present value			212,654
This project should be Accepted			Accepted
[Positive NPV is accepted]