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 is financially 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%. Assume that all cash flows are made at the end of each year.

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

Sol:

Based the information furnished above the key important calculations are doing as follows

Statement of incremental cashflows
Year	Units (Reduce every year by 10%)      ( A )	Rate per unit(reduce every year by 8%)   ( B )	Sales [ C =A*B ]	Sales Return (5% of sales)    [ D =5% of C ]	Variable Cost (40% of sale)                       [ E = C*40%]	Deprciation      [ F ]	Profit before tax [ G = C-D-E-F ]	Tax (30%)	Netprofit	Cash Flow	incremental cash flow
0
1	80,000	$300	=80,000 x 300= $24,000,000	$1,200,000	=24,000,000 x 40%= $9,600,000	=$22,000,000/5 =$4,400,000	8800000	2640000	6160000	=net profit + Dep = 10,560,000	1,05,60,000
2	72000	$276	=72000 x 276= $19,872,000	$993,600	$7,948,800	$4,400,000	6529600	1958880	4570720	=8,970,720	1,95,30,720
3	64800	$254	=64800 x 254= $16,459,200	$822,960	$6,583,680	$4,400,000	4652560	1422768	3229792	=7,629,792	2,71,60,512
4	58320	$234	=58320 x 234= $13,646,880	$682,344	$5,458,752	$4,400,000	3105784	931736	2174048	=6,574,048	3,37,34,560
5	52488	$215	=52488 x 215= $11,284,920	$564,246	$4,513,968	$4,400,000	1806706	542012	1264694	=5,664,694	3,93,99,254

Payback period
Year	0	1	2	3	4	5
Inital Cost	80,00,000	0	0	0	0	0
Cost of equipment	2,20,00,000	0	0	0	0	0
Cash inflows	-	1,05,60,000	89,70,720	76,29,792	65,74,048	56,64,694
Payback
Payback= 3yrs + (6,574,048/365) x 3734560
=3yrs + 208 days