Question

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	$4,000,000	Estimated useful life	15 years
Annual cash inflows	4,000,000	Salvage value	$2,000,000
Annual cash outflows	3,540,000	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 $200,000 higher than projected above, and that the savings from lower warranty costs and legal costs will be $60,000 per year. He also believes that the project is not as risky as assumed above, and that a 9% discount rate is more reasonable.

Instructions

Answer each of the following.

(a)Compute the net present value of the project based on the original projections.

(b)Compute the net present value incorporating Bob's estimates of the value of the intangible benefits, but still using the 11% discount rate.

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

(d)Comment on your findings.

Answer 1

(a)

Intitial investment	(4,000,000)
PV of cash inflows over 15 years	3,307,814
PV of salvage value	418,000
NPV	(274,186)

PV of cash inflows over 15 years = [(4,000,000 - 3,540,000) x PVAF (11%,15 years)]

= 460,000 x 7.1909 = 3,307,814

PV of salvage value after 15 years = 2,000,000 x PVF (11%, year 15) = 2,000,000 x 0.2090 = 418,000

(b)

Intitial investment	(4,000,000)
PV of cash inflows over 15 years	5,177,448
PV of salvage value	418,000
NPV	1,595,448

PV of cash inflows over 15 years = [(4,000,000 - 3,540,000 + 200,000 + 60,000) x PVAF (11%,15 years)]

= 720,000 x 7.1909 = 5,177,448

(c)

Intitial investment	(4,000,000)
PV of cash inflows over 15 years	3,707,922
PV of salvage value	549,000
NPV	256,922

PV of cash inflows over 15 years = [(4,000,000 - 3,540,000) x PVAF (9%,15 years)]

= 460,000 x 8.0607 = 3,707,922

PV of salvage value after 15 years = 2,000,000 x PVF (9%, year 15) = 2,000,000 x 0.2745 = 549,000

(d) A lower discount rate will lead to a higher NPV.

If the Project can function as per Bob's suggestions, the project will be beneficial. Otherwise, it has a negative NPV (as found in part a)