Question

Cleveland Enterprises is considering the addition of a new product line.  The firm would not need additional factory space, but it would require the purchase of $2.45 million of equipment installed.  The equipment would be depreciated using a 7-year accelerated depreciation schedule.  Additional inventory of 13% of the projected increase in next year’s sales would be necessary prior to each year of operation, but the entire value will be recovered at the end of the project.  The firm expects to sell 340,000 units during the first year of the project, increasing to 355,000 units during the next three years before decreasing to 100,000 during the fifth and final year of the project.  The product is expected to be obsolete at that point.  The expected sales price is $13 per unit with a variable cost of $6 per unit during the first year of operations.  Variable costs will increase by 5% per year, but the sales price remains fixed.  Fixed costs are estimated at $610,000 during the first year, but will increase by 6% per year.  The firm’s tax rate is 21%.  The equipment has an estimated salvage value of $500,000.

What is the estimated net present value of the project assuming a required return of 18%?

Management of the firm is predicting the possibility of an economic boom during the upcoming years.  If so, the projected sales would be 380,000 units per year with a price of $14.  However, it would also increase labor costs giving the firm a variable cost per unit of $8 in the first year, with subsequent increases as discussed above.  

What is the estimated net present value of the project assuming an economic boom?

Based on your calculations, what recommendations would you make to the management of Cleveland Enterprises?

Answer 1

1]		0	1	2	3	4	5
	Production in units		340000	355000	355000	355000	100000
	Price per unit		$            13.00	$            13.00	$ 13.00	$ 13.00	$ 13.00
	Variable cost per unit		$ 6.00	$ 6.30	$ 6.62	$ 6.95	$ 7.29
	Sales		$    44,20,000	$ 46,15,000	$   46,15,000	$ 46,15,000	$   13,00,000
	Variable cost		$    20,40,000	$ 22,36,500	$   23,50,100	$ 24,67,250	$      7,29,000
	Fixed costs other than depreciation		$      6,10,000	$      6,46,600	$     6,85,396	$    7,26,520	$      7,70,111
	Depreciation rate [%]		14.29	24.49	17.49	12.49	8.93	Total Depn	Book Value
	Depreciation expense		$      3,50,105	$      6,00,005	$     4,28,505	$    3,06,005	$      2,18,785	$     19,03,405	$        5,46,595
	NOI		$    14,19,895	$   11,31,895	$   11,50,999	$ 11,15,225	$    -4,17,896
	Tax at 21%		$      2,98,178	$      2,37,698	$     2,41,710	$    2,34,197	$        -87,758
	NOPAT		$    11,21,717	$      8,94,197	$     9,09,289	$    8,81,028	$    -3,30,138
	Add: Depreciation		$      3,50,105	$      6,00,005	$     4,28,505	$    3,06,005	$      2,18,785
	OCF		$    14,71,822	$   14,94,202	$   13,37,794	$ 11,87,033	$    -1,11,353
	Capital expenditure	$ 24,50,000
	Change in NWC	$      5,74,600	$          25,350	$                   -	$                  -	$ -4,30,950	$    -1,69,000
	After tax salvage value = 500000+(546595-500000)*21% =						$      5,09,785
	Annual project cash flows	$ -30,24,600	$    14,46,472	$   14,94,202	$   13,37,794	$ 16,17,983	$      5,67,432
	PVIF at 18%	1	0.84746	0.71818	0.60863	0.51579	0.43711
	PV at 18%	$ -30,24,600	$    12,25,824	$   10,73,113	$     8,14,223	$    8,34,538	$      2,48,030
	NPV	$   11,71,127
2]	UNDER BOOM CONDITIONS:
	Sales [380000*14]		$    53,20,000	$   53,20,000	$   53,20,000	$ 53,20,000	$   53,20,000
	Variable cost per unit		$ 8.00	$ 8.40	$ 8.82	$ 9.26	$ 9.72
	Total variable cost		$    30,40,000	$   31,92,000	$   33,51,600	$ 35,18,800	$   36,93,600
	Contribution margin under boom		$    22,80,000	$   21,28,000	$   19,68,400	$ 18,01,200	$   16,26,400
	Contribution margin when normal		$    23,80,000	$   23,78,500	$   22,64,900	$ 21,47,750	$ 5,71,000
	Increase in contribution margin under boom		$     -1,00,000	$    -2,50,500	$   -2,96,500	$ -3,46,550	$   10,55,400
	PVIF at 18%	1	0.84746	0.71818	0.60863	0.51579	0.43711
	PV at 18%	$                   -	$        -84,746	$    -1,79,905	$   -1,80,459	$ -1,78,747	$ 4,61,325
	PV of increase in contibution margin	$    -1,62,532
	NPV under boom [1171127-162532]	$   10,08,595
3]	As the NPV is positive under normal and boom conditions, the project is viable and should be implemented,