Question

Sprint Bolt Ltd is a producer of specialised sport shoes. The company has been conducting research and development of a new model, where the lower mould can automatically adjust itself to avoid foot injury. The model has been tested and the managing board is happy to launch its production if it's financial viable. The company has already spent $800,000 for research and development. The new model will have a five-year lifetime, after that the company will stop its production. The new production facilities and equipment will cost $22,000,000 which will be depreciated on a straight line basis to zero book value. The company will not sell the equipment after the production of new product is finished.

The company expects to sell 80,000 pairs in the first year at $300 per pair. As the new technique can be potentially followed by competitors, every year the sale quantity is expected to decrease by 10% and the sale price will decrease by 8%. Variable costs are expected to be 40% of sales. While the new model generates a high gross profit rate, the company expects a high level of product returns of 5% on sales.

As a financial manager of the company, you’re conducting a capital budgeting analysis of the financial viability of the new model.

The company tax rate is 30%. Company’s required payback is 2 years and required rate of return is 25%.

1. Calculate the incremental cash flows for each year (Y₀ to Y₅ inclusive).

2. Calculate the payback period of the project.

3. Calculate the net present value, that is, the net benefit or net loss in present value terms of the project.

4. Calculate the present value index of the project.

5. Calculate the discounted payback period of the project.

6. Calculate the internal rate of return of the project.

7. Identify and explain what other factors Sprint Sport should consider. Explain if the company should accept the project or not.

Answer 1

To calculate the incremental cash flows, we need Cash flow after taxes.

Here, the formula we have used:

EBT = sales- sales return- Variable cost- Depreciation

EAT= EBT- Tax

CFAT= EAT + Depreciation

After that we will find the cumulative csh flows or incremental cash flows