Question

Golden Gate Windsurfing Inc. is considering a project to introduce a new product line and has just received the results of a market research study about this expansion. The project life is expected to be 5 years. The company plans to set up its new operation in its own building site, which was purchased last year at a cost of $800,000. The building site has the current market value of $900,000.

The study estimated the sales and expenses as follow:

• Annual cash sale is $450,000 in the first year, and increases by 2% per year thereafter
• Expected costs:
• Variable costs                    20% of Sales revenue per year
• Fixed costs                          $90,000 per year, increases by 2% per year thereafter

Other relevant information to estimate cash flows is as follow.

• Market research study costs $25,000
• Necessary foundry and machining equipment will initially cost a total of $420,000 and will be depreciated on a straight-line basis to zero over the project’s life. The firm expects to sell the equipment for $90,000 at the end of year 5.
• An initial working capital of $25,000 is required. In the following year, working capital is maintained as 12% of sales. All the working capital will be recovered on closure of the project
• If proceed the project, Golden Gate will lose sales to the value of $80,000 in year 1 and $71,000 in year 2 on their existing products
• Corporate tax rate is 25%, and the company requires a rate of return of 12% in order to invest in this project.

Required: Using the NPV method, evaluate whether Golden Gate Windsurfing Inc. should proceed with the project?

DO IT ON EXCEL

Answer 1

Computation of the Net Present Value

Since , the land value after the project is not provided in the question, assuming that land value remains same after the end of the project

Computation of the Oppurtunity cost of land:

Year	Cash flow	Disc @ 12%	Discouning factor	Discounted cash flows
5	$900,000	1/(1.12)^5	0.567426856	$510,684.17

So the present value of land is $ 510684( the land cannot be sold because of execution of the project). But if we have not undertaken the project , we can currently sell the land for $ 900000.

Oppurtunity cost of land= $ 900000-$ 510684=$ 389136

Computation of the Cash inflow

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Annual cash sale	$450,000	$459,000.00	$468,180.00	$477,543.60	$487,094.47	$2,341,818
Less: Variable cost	$90,000.0	$91,800.0	$93,636.0	$95,508.7	$97,418.9	$468,364
Less: Fixed Cost	$90,000	$91,800.00	$93,636.00	$95,508.72	$97,418.89	$468,364
Less: Depreciation	$84,000	$84,000	$84,000	$84,000	$84,000	$420,000
Profit	$186,000.0	$191,400.0	$196,908.0	$202,526.2	$208,256.7	$985,091
Less: Corporate Tax @ 25%	$46,500.00	$47,850.00	$49,227.00	$50,631.54	$52,064.17	$246,273
Profit after Tax	$139,500.00	$143,550.00	$147,681.00	$151,894.62	$156,192.51	$738,818
Net Profit ( % )	$31.00	$31.27	$31.54	$31.81	$32.07
Add: Depreciation	$84,000	$84,000	$84,000	$84,000	$84,000	$420,000
Annual cash inflow	$223,500.00	$227,550.00	$231,681.00	$235,894.62	$240,192.51	$1,158,818
Discounting factor @ 12%	0.892857143	0.797193878	0.738142479	0.683465259	0.6328382
Discounted cash flow	$199,553.57	$181,401.47	$171,013.59	$161,225.78	$152,003.00	$865,197

Computation of the working capital

S.No	Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Total
A	Annual cash sales	$0	$450,000	$459,000.00	$468,180.00	$477,543.60	$487,094.47	$2,341,818
B	Intial working capital	$25,000						$25,000
C	Maintanance of working capital	$0	$54,000.00	$55,080.00	$56,181.60	$57,305.23	$58,451.34	$281,018
D	Total cash outflow( B+C)	$25,000	$54,000	$55,080	$56,182	$57,305	$58,451	$306,018
E	Discounting factor @ 12%	1	0.892857143	0.797193878	0.738142479	0.68346526	0.632838202
F	Working capitl outfllow( Discounted value)( D*E)	$25,000	$48,214	$43,909	$41,470	$39,166	$36,990	$234,750

Recovery of the working capital at the Year 5

A	Total working capital inccurred from Year 0 to Year 5	$281,018
B	Discounting factor @ 12% at year 5	1/(1.12)^5
C	Discounting factor.	0.567426856
D	Present Value( A*C)	$159,457.26

Computation of Net working capital used

S.No	Particulars	Amount
A	PV of the working capital outflow	$234,750
B	PV of the working ccapital inflow	$159,457.26
C	Net working capital used( A-B)	$75,292.87

Computation of the oppurtunity cost on lost sales

Particulars	Year 1	Year 2	Total
Cash sales	$80,000	$71,000	$151,000
Oppurtunity cost @ 12% ( minimum return)	$9,600.00	$8,520.00	$18,120.00
Discounting factor @ 12%	0.892857143	0.797193878
Discounted cash flow	$8,571.43	$6,792.09	$15,363.52

Since the entite lost sales is not the opputrtunity cost.Only profit on such sales is the oppurtunity cost.Since we don’t know the profit trend in the existing sales,so we assumed minimum 12% return.

Computation of the Net Preent Value
Particulars	Amount
Machnary Cost	($420,000)
Oppurtunity cost on land	($389,316)
Net working capital used	($75,292)
Oppurtunity cost on lost sales	($15,363)
Cash inflow on sales	$865,197
Sale value of machinary	$42,716.58
NPV.	$7,943

Since NPV is posiitive we have to accetpt the project.

Computation of recovery amount from the machine
Particulars	Amount
Sale value	$90,000
Less: tax @ 25%	$22,500.00
Cash flow after tax	$67,500.00
Disc @ 12% for fifth year	0.632838202
Discounted present valur	$42,716.58