Question

You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago for $2.9 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $3.1 million on an aftertax basis. In four years, the land could be sold for $3.3 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $375,000. An excerpt of the marketing report is as follows: The zither industry will have a rapid expansion in the next four years. With the brand name recognition that PUTZ brings to bear, we feel that the company will be able to sell 7,100, 7,800, 8,400, and 6,700 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $525 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued. PUTZ believes that fixed costs for the project will be $755,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $3.65 million and qualifies for 100 percent bonus depreciation in the first year. At the end of the project, the equipment can be scrapped for $615,000. Net working capital of $325,000 will be required immediately. PUTZ has a tax rate of 25 percent, and the required return on the project is 13 percent. What is the NPV of the project?

Answer 1

The $2.9 million cost of the land 3 years ago is a sunk cost and irrelevant. The $3.1 million after-tax sale price of the land today is an opportunity cost and is relevant. The $3.3 million after-tax sale price of the land in 4 years is a relevant cash flow as well. The fact that the company is keeping the land rather than selling it is unimportant. The land is an opportunity cost in 4 years and is a relevant cash flow for this project

The amount of $375,000 paid to the marketing firm is also a sunk cost.

Operating cash flow (OCF) each year = income after tax + depreciation

In year 4, the entire working capital investment is recovered.

profit on sale of equipment at end of year 4 = sale price - book value

The book value is zero as the equipment is fully depreciated

after-tax salvage value = salvage value - tax on profit sale of equipment   

NPV is calculated using NPV function in Excel

NPV is $2,025,492