Question

This question has two very different solutions previously, can another teacher confirm the right answer with steps? Thank you so much. It is worth 20 marks.

You are evaluating a project for The Ultimate recreational tennis racket, guaranteed to correct that wimpy backhand. You estimate the unit sales price of The Ultimate to be $500 and sales volume to be 1,000 units in year 1; 1,250 units in year 2, and 1,450 units in year 3. The project has a three year life. Variable costs amount to $225 per unit and fixed costs, excluding depreciation, are $110,000 per year. The project requires an initial investment of $170,000 which is depreciated straight-line to zero over the three-year project life. The expected scrap value of the asset at the end of year 3 is $35,000. Net working capital investment is initially lowered by $80,000 and it will be fully replaced at the end of the project’s life. The tax rate is 34% and the required return on the project is 10%. What is the NPV of this project? Accordingly what is your decision?

Answer 1

Tax rate		34%
Calculation of annual depreciation
Depreciation		Year-1	Year-2	Year-3			Total
Cost		$       170,000	$      170,000	$       170,000
Dep Rate		33.33%	33.33%	33.33%
Depreciation	Cost * Dep rate	$         56,667	$        56,667	$         56,667			$       170,000
Calculation of after-tax salvage value
Cost of machine			$      170,000
Depreciation			$      170,000
WDV	Cost less accumulated depreciation	$                -
Sale price			$        35,000
Profit/(Loss)	Sale price less WDV	$        35,000
Tax	Profit/(Loss)*tax rate	$        11,900
Sale price after-tax	Sale price less tax		$        23,100
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3
No of units		1,000	1,250	1,450
Selling price		$              500	$             500	$              500
Operating ost		$              225	$             225	$              225
Sale		$       500,000	$      625,000	$       725,000
Less: Operating Cost		$       225,000	$      281,250	$       326,250
Contribution		$       275,000	$      343,750	$       398,750
Less: Fixed cost		$       110,000	$      110,000	$       110,000
Less: Depreciation		$         56,667	$        56,667	$         56,667
Profit before tax (PBT)		$       108,333	$      177,083	$       232,083
Tax@34%	PBT*Tax rate	$         36,833	$        60,208	$         78,908
Profit After Tax (PAT)	PBT - Tax	$         71,500	$      116,875	$       153,175
Add Depreciation	PAT + Dep	$         56,667	$        56,667	$         56,667
Cash Profit after-tax		$       128,167	$      173,542	$       209,842
Calculation of NPV
						10.00%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor, 1/(1+r)^time	Present values
0		$     (170,000)	$       (80,000)		$     (250,000)	1.0000	$(250,000.00)
1				$       128,167	$       128,167	0.9091	$ 116,515.15
2				$       173,542	$       173,542	0.8264	$ 143,422.87
3		$         23,100	$        80,000	$       209,842	$       312,942	0.7513	$ 235,117.71
					Net Present Value	$ 245,055.72

Since NPV is positive, it is suggested to go for the investment.