Question

Aussie Ltd has decided to sell a new line of golf clubs. The club will sell for $700 per set and have a variable cost of $340 per set. The company has spent $150,000 for a marketing study that determined the company will sell 46,000 sets per year for seven years. The marketing study also determined that the company will lose sales of 12,000 sets of its high-priced clubs. The high-priced clubs sell at $1100 and have variable costs of $550. The company will also increase sales of its cheap clubs by 20,000 sets. The cheap clubs will sell for $300 and have variable costs of $100 per set. The fixed costs each year will be $8,000,000. The company has also spent $1,000,000 on research and development for the new clubs. The plant and equipment required will cost $16,100,000 and will be depreciated on a straight line basis. The new clubs will also require an increase in net working capital of $900,000 and that will be returned at the end of the project. The tax rate is 30%, and the cost of capital is 14%. Required Calculate the Payback Period and Net Present Value followed by your recommendations.

Answer 1

Discounted Payback period (DPP)

Step 1: We must pick the year in which the PV of cash outflows have become positive. In other words, the year with the last negative outflow has to be selected. So, in this case, it will be year five.

Step 2: Divide the PV of total cumulative cash flow in the year in which the cash flows became positive by the PV of total cash flow of the consecutive year.

So that is: $1,457,781.60 / $2,215,127.50 = 0.66

Step 3: Step 1 + Step 2 = The DPP is 5.71 years.

Net present value is $3,059,840.80 and its positive therefore the New line of gold club should be continue.

Note 1 - Working capital invested will be returned at the end of 7th year (as mentioned in the question)

Note 2 - Payback period calculated after considering the PV effect, it will be more accurate than regular payback period. Since this will include the impact of time value of money as well.