Question

1. Pong Golf has decided to sell a new line of golf clubs. The clubs will sell for $825 per set and have a variable cost of $415 per set. The company has spent $250,000 for a marketing study that determined the company will sell 68,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 9,500 sets per year of its high-priced clubs. The high-priced clubs sell at $1,275 and have variable costs of $580. The company will also increase sales of its cheap clubs by 10,250 sets per year. The cheap clubs sell for $395 and have variable costs of $195 per set. The fixed costs each year will be $18,500,000. The company has also spent $1,800,000 on research and development for the new clubs. The plant and equipment required will cost $27,500,000 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 $1,250,000 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 22 percent, and the cost of capital is 15 percent.

1. Calculate the payback period, the NPV and the IRR.
2. Test the sensitivity of NPV and IRR to a $30 decrease in the price of the new clubs.
3. Test the sensitivity of NPV and IRR to a $25 increase in the variable cost of the new clubs.

Answer 1

The $250,000 expense for the marketing study is ignored because it is a Sunk Cost and hence, is not included for capital budgeting.

The $1,800,000 research and development expense for the new clubs is also ignored because it is a Sunk Cost.

Total initial capital expenditure = Cost of the plant and equipment + Net working capital investment

Total initial capital expenditure = $27,500,000 + $1,250,000 = $28,750,000

Depreciation is charged for 7 years using the MACRS seven-year useful life table. Following are the depreciation rates:

Depreciation for the year = Depreciation rate * Purchased Asset Value

Depreciation for the year 1 = 14.29%*27,500,000 = $3,929,750

Asset Value at the end of Year 1 = Beginning Value of Asset - Depreciation for the year 1

Asset Value at the end of Year 1 = $27,500,000 - $3,929,750 = $23,570,250

Similarly, Depreciation and asset values for the other years are calculated:

The asset is sold at its book value at the end of the 7th year, i.e., $12,26,500. So, there is no gain or loss on the sale of assets at the end of the 7th year, hence, no tax is charged on this salvage value.

Salvage value at the end of year 7 =  $12,26,500

After-tax Salvage Value = Pre-tax Salvage Value - Taxes =  $12,26,500 - 0 = $12,26,500

Revenue from sales of new golf sets in year 1 = Price per set * Quantity Sold = $825*68000 = $56,100,000

Total variable cost for new golf sets in year 1 = Variable cost per unit * Quantity Sold = $415*68000 = $28,220,000

Cannibalization Effect 1: Increase in sales of its cheap clubs

Quantity more sold each year = 10,250 sets per year

Price per unit = $395

Variable costs per unit = $195

Total sales added for each year = Price per unit*Increase in Sales quantity = $395*10,250 = $4,048,750

Total variable costs for each year = Variable costs per unit * Increase in Sales quantity = $195* 10,250 = $1,998,750

Net increase in sales for each year = $4,048,750 - $1,998,750 = $2,050,000

Cannibalization Effect 2: Increase in sales of its cheap clubs

Quantity lost each year= 9,500 sets per year

Price per unit = $1,275

Variable costs per unit = $580

Total sales lost for each year = Price per unit*Increase in Sales quantity = $1275*9500 = $12,112,500

Total variable costs for each year = Variable costs per unit * Increase in Sales quantity = $580* 9500 = $5,510,000

Net loss in sales for each year = $12,112,500 - $5,510,000 = $6,602,500

Net Sale including the effect of cannibalization:

Pro forma Income statement is made as follows:

The Operating Cash Flows (OCF) are calculated as below:

Total Cash Flows are calculated as follows:

Case 1: The sensitivity of NPV and IRR to a $30 decrease in the price of the new clubs

New price of the golf clubs = $825 - $30 = $795

The total cash flows in this case are:

Case 2: The sensitivity of NPV and IRR to a $25 increase in the variable cost of the new clubs.

New variable costs = $415 + $25 = $440

The total cash flows in this case are: