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

The test marketing and feasibility test costs of GHc 250,000 and GHc 100,000 are sunk costs and will not be considered for decision making.

The sale value of land and vacant building, GHc 150,000 is the opportunity cost. It has been assumed in the calculation that the land can be sold at the same price at the end of year 5.

Interest of $20,000 per year not to be considered as the company is already paying and the decision will not affect that costs.

Computation of Net Present Value.

	Year		1	2	3	4	5
	Units		5000	8000	12000	10000	6000
1	Sale Price		20.00	20.40	20.81	21.23	21.65
2	Production cash outflows		10.00	11.00	12.10	13.31	14.64
3	Net Cash Inflow		10.00	9.40	8.71	7.92	7.01
4	Total Net Cash Inflow		50,000.00	75,200.00	104,520.00	79,200.00	42,060.00
5	Depreciation		14,000.00	14,000.00	14,000.00	14,000.00	14,000.00
6	Profit Before Tax (4 -5)		36,000.00	61,200.00	90,520.00	65,200.00	28,060.00
7	Tax @ 34%		12,240.00	20,808.00	30,776.80	22,168.00	9,540.40
8	Profit After Tax (6 -7)		23,760.00	40,392.00	59,743.20	43,032.00	18,519.60
9	Depreciation		14,000.00	14,000.00	14,000.00	14,000.00	14,000.00
10	Cash Flows After Tax (8 + 9)		37,760.00	54,392.00	73,743.20	57,032.00	32,519.60
11	Salvage Value of Machine						30,000.00
12	Opportunity cost of Land	(150,000.00)					150,000.00
13	Additional Net Working Capital	(10,000.00)	(6,320.00)	(8,652.00)	3,742.00	8,240.00	12,990.00
14	Cost of Machine	(100,000.00)
16	Net Cash Flows After Tax ( 10 + 11 + 12 + 13+ 14)	(260,000.00)	31,440.00	45,740.00	77,485.20	65,272.00	225,509.60
17	PVF @ 15%	1.000	0.870	0.756	0.658	0.572	0.497
18	Present Value (16 * 17)	(260,000.00)	27,352.80	34,579.44	50,985.26	37,335.58	112,078.27
	Net Present Value						2,331.36