Question

Rocky Road Bikes is evaluating the possibility of offering a new top-of-the-line bike model. The company’s market research team estimates that first year sales of the new model will be 25,000 units at the proposed price of $750.00 per unit and estimated cost per unit of $275.00. Sales are expected to grow 4% per year in each of the following 5 years, until the new model is discontinued at the end of year 6. The market research team also estimates the introduction of the new model will erode sales of the current top model by a constant 5,000 units per year. The current top model has a price of $500.00 and associated costs of $145.00. The required tooling and machinery to manufacture the new model will cost a total of $15,000,000, and this will be depreciated on a straight-line basis over the six-year life of the project to zero. The company expects to be able to sell the machinery at the end of the project for $3,000,000. There will also be fixed costs associated with the new model of $6,000,000 per year. The new model will require an increase in working capital of $250,000 which will be returned at the end of the project. Rocky Road has a tax rate of 35%, and management believes that the discount rate for this project should be 12%. What is the Payout Period, the NPV, and the IRR of this project?

Answer 1

NPV = 762,900.40

IRR = 13.53%

Payback period calculation:

Cumulative cash flows turn positive in Year 5, so fraction of Year 5 = CFCF in Year 4/FCF in Year 5

= 1,672,606/4,229,845.76 = 0.395

Total payback period = 4 years + 0.395 of a year = 4.395 years