Question

The GFA Company, originally established 16 years ago to make footballs, is now a leading producer of tennis balls, baseballs, footballs, and golf balls. Nine years ago, the company introduced “High Flite,” its first line of high-performance golf balls. GFA management has sought opportunities in whatever businesses seem to have some potential for cash flow. Recently Mr Dawadawa, vice president of the GFA Company, identified another segment of the sports ball market that looked promising and that he felt was not adequately served by larger manufacturers.
As a result, the GFA Company investigated the marketing potential of brightly coloured bowling balls. GFA sent a questionnaire to consumers in three markets: Accra, Kumasi, and Koforidua. The results of the three questionnaires were much better than expected and supported the conclusion that the brightly coloured bowling balls could achieve a 10 to 15 percent share of the market. Of course, some people at GFA complained about the cost of the test marketing, which was GH¢ 250,000. In addition, feasibility test carried out by analyst to assess the viability of the project cost GH¢ 100,000
In any case, the GFA Company is now considering investing in a machine to produce bowling balls. The bowling balls would be manufactured in a building owned by the firm and located near Madina. This building, which is vacant, and the land can be sold for GH¢ 150,000 after taxes.
Working with his staff, Dawadawa is preparing an analysis of the proposed new product. He summarizes his assumptions as follows: The cost of the bowling ball machine is GH¢100,000 and it is expected to last five years. At the end of five years, the machine will be sold at a price estimated to be GH¢ 30,000. The machine is depreciated on straight line basis. The company is exempt from capital gains tax. Production by year during the five-year life of the machine is expected to be as follows: 5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units. The price of bowling balls in the first year will be GH¢20. The bowling ball market is highly competitive, so Dawadawa believes that the price of bowling balls will increase at only 2 percent per year, as compared to the anticipated general inflation rate of 5 percent.
Conversely, the plastic used to produce bowling balls is rapidly becoming more expensive. Because of this, production cash outflows are expected to grow at 10 percent per year. First-year production costs will be GH¢10 per unit. Dawadawa has determined, based on GFA’s taxable income, that the appropriate incremental corporate tax rate in the bowling ball project is 34 percent.
Like any other manufacturing firm, GFA finds that it must maintain an investment in working capital. Management determines that an initial investment (at Year 0) in net working capital of GH¢10,000 is required. Subsequently, net working capital at the end of each year will be equal to 10 percent of sales for that year. In the final year of the project, net working capital will decline to zero as the project is wound down. In other words, the investment in working capital is to be completely recovered by the end of the project’s life. Again, the company paid GH¢20,000 per year in interest on loans contracted from Kelewele Bank Ghana Limited.
The required rate of return of the project is 15%.
Required:
Evaluate the project using NPV and advise the Management of GFA whether or not it should introduce the bowling balls      

Answer 1

To make a decision, we will have to consider the costs that have to be incurred from now on. Costs already incurred do not affect our decision, since they are sunk costs (they cannot be recovered in any case).

List of expenses in Year 0 (in GH¢)
Particular	Expense	Remark
Test Marketing	250,000	Already incurred, thus, does not affect our decision
Feasibility Test	100,000	Already incurred, thus, does not affect our decision
Building and Land (net of tax)	150,000	Opportunity Cost, to be considered
Cost of bowling ball machine	100,000	Straight line depreciation over 5 years, Salvage value = 30,000
		Exempt from Capital Gains Tax, thus salvage value is not affected
Total initial investment to be considered	250,000

Calculations for Profit and Loss, and Cash Flow Analysis
Corporate Tax Rate	34%
Required Rate of Return	15%
Year	0	1	2	3	4	5	Remark
Production units		5,000	8,000	12,000	10,000	6,000	Given
Per unit price		20.00	20.40	20.81	21.22	21.65	Grows at 2%
Per unit production cost		10.00	11.00	12.10	13.31	14.64	Grows at 10%
Sales		100,000.00	163,200.00	249,696.00	212,241.60	129,891.86	Assumed that entire production units are sold
WC	10,000.00	10,000.00	16,320.00	24,969.60	21,224.16	-	10% of sales
Interest		20,000.00	20,000.00	20,000.00	20,000.00	20,000.00
Salvage Value of Machine	30,000.00
Profit and Loss Calculation
Year	0	1	2	3	4	5
Sales		100,000.00	163,200.00	249,696.00	212,241.60	129,891.86
Cost of Goods Sold		50,000.00	88,000.00	145,200.00	133,100.00	87,846.00
Gross Margin		50,000.00	75,200.00	104,496.00	79,141.60	42,045.86
Depreciation		14,000.00	14,000.00	14,000.00	14,000.00	14,000.00	Using straight-line method, depreciation = (Cost - Salvage Value) / Life
							Thus, depreciation = (100,000 - 30,000) / 5 = 14,000
Interest Expense		20,000.00	20,000.00	20,000.00	20,000.00	20,000.00
Profit Before Tax		16,000.00	41,200.00	70,496.00	45,141.60	8,045.86
Tax		5,440.00	14,008.00	23,968.64	15,348.14	2,735.59
Profit After Tax		10,560.00	27,192.00	46,527.36	29,793.46	5,310.27
Cash Flow Calculation							Negative is outflow and positive is inflow
Year	0	1	2	3	4	5
Profit After Tax		10,560.00	27,192.00	46,527.36	29,793.46	5,310.27
Change in WC	(10,000.00)	-	(6,320.00)	(8,649.60)	3,745.44	21,224.16
Depreciation Add-Back		14,000.00	14,000.00	14,000.00	14,000.00	14,000.00
Salvage Value						30,000.00
Initial Investment	(250,000)
Total Cash Flow	(260,000.00)	24,560.00	34,872.00	51,877.76	47,538.90	70,534.43
Discounted Cash Flow	(260,000.00)	21,356.52	26,368.24	34,110.47	27,180.52	35,068.08	Calculated as the present value (PV) of future cash flow (FCF)
							PV = FCF / (1+r)^n
Net Present Value (NPV)	(115,916.17)

The NPV of the project is negative at the end of the project timeline (i.e. 5 years). Thus the Management of GFA should not introduce the bowling balls.