Question

Gordy’s Golf has decided to sell a new line of golf clubs. The clubs will sell for $790 per set and have a variable cost of $375 per set. The company has spent $250,000 for a marketing study that determined the company will sell 88,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 9,750 sets per year of its high-priced clubs. The high-priced clubs sell at $1,350 and have variable costs of $625. The company will also increase sales of its cheap clubs by 12,000 sets per year. The cheap clubs sell for $325 and have variable costs of $125 per set. The fixed costs each year will be $17,500,000. The company has also spent $1,800,000 on research and development for the new clubs. The plant and equipment required will cost $40,500,000 and will be depreciated using the MACRS seven-year useful life table. The new clubs will also require an increase in net working capital of $2,300,000 that will be returned at the end of the project. At the end of the projects life, the capital equipment will be sold for its book value. The tax rate is 25 percent, and the cost of capital is 18.5 percent.

(SHOW ALL FORMULAS IN EXCEL)

a. Calculate the payback period, the NPV and the IRR.

b. Test the sensitivity of NPV and IRR to a $30 decrease in the price of the new clubs.

c. Test the sensitivity of NPV and IRR to a $25 increase in the variable cost of the new clubs.

Answer 1

a]

Operating cash flow (OCF) each year = Incremental earnings after tax + depreciation

Incremental earnings after tax = Incremental earnings before tax - taxes

Incremental earnings before tax = revenues - variable costs - fixed costs - depreciation - decreased contribution of high-priced clubs + increased contribution of cheap clubs

Decreased contribution of high-priced clubs = lost sales units * (sale price - variable cost)

Increased contribution of cheap clubs = increased sales units * (sale price - variable cost)

In year 7, the entire working capital investment is recovered.

NPV and IRR are calculated using NPV and IRR functions in Excel

NPV is $4,031,034.24

IRR is 21.79%

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = 3 + (cash flow required in year 4 for cumulative cash flows to equal zero / year 4 cash flow) = 3 + ($4,812,350 / $12,028,050) = 3.40 years

b]

$30 decrease in the price of the new clubs

NPV is -$3,409,810.77

IRR is 15.63%

c]

$25 increase in the variable costs of the new clubs

NPV is -$2,169,669.94

IRR is 16.68%